Inverted Yield Curve

The inverted yield curve is a graph that depicts long-term debt instruments yielding fewer returns than short-term. It’s a rare phenomenon and usually precedes a financial breakdown. The best example is the inversion of yield before the great financial crisis of 2007. Hence also known as predictors of crisis; in fact, they are often seen as accurate forecasters of a financial disaster because of the historical correlation between the two.

It is hard to outperform the market based only on fundamental knowledge. Therefore, investors need to make prudent decisions by using valuable tools like the yield curve. While nothing can accurately predict interest rate changes except the government itself, sagaciously tracking the yield movements can help investors anticipate near to mid-term changes in the economy.

• The "inverted yield curve" signifies a scenario where long-term debt instruments offer lower returns than short-term ones. This phenomenon is rare and often precedes financial crises, as seen in the lead-up to the Great Financial Crisis of 2007. Consequently, it's often referred to as a predictor of crises.
• Due to their historical correlation, inverted yield curves are frequently considered reliable indicators of impending financial disasters.
• The economy's state significantly influences the yield curve's shape. While long-term bonds may sometimes yield higher returns, they can experience reduced returns if overall interest rates rise.

The inverted yield curve chart is a graphical representation of the fact that sometimes, the yield of short-term debt instruments or bonds are higher than the long-term ones. It is also called negative yield curve.

The normal yield curve is a curve that depicts short-term bond's yielding lower returns as compared to long-term bonds of the same class. The curve slopes in an upward fashion to indicate rising yields, as the investor expects higher compensation in the long run, which comes with higher uncertainties. Hence a rising curve, a normal yield curve, is also called a positive yield curve.

But in this yield curve becomes inverted, it suggests that the economy is portraying a pessimistic situation where the inverted yield curve bonds project a possibility of recession.

The inverted yield curve chart is an important part of economic cycles leading to economic downturns. They have historically rendered timely signals for economic changes, exhibiting the market’s opinions on the current economic scenario. The inverted yield curve has been a unique phenomenon largely due to prolonged periods between economic downturns since the 1990s.

Yields are moved by the demand and supply factors in the economy. When the economy moves towards recession and the interest rates are on their way to the south, investors are more inclined toward long-term securities to lock in higher yields. As a result of increased demand for long-term securities, the prices go up, compelling the yields to go down, showing inverted yield curve bonds. And as the demand for short-term securities goes down, their yields increase.

Now let us analyse some of the causes that may make the yield curve inverted. A normal curve may hold on as long as the economy is growing; however, it may begin to diverge as the economic activity slows down. One of the major causes of this co-relation is how the market players think the capital investments are going to weigh in on the oncoming economic changes or stimulate the economy as a whole.

• Debt securities, by nature, are very sensitive to government policies and interest rates. While short-term bonds are more reactive to interest rates as compared to long-term bonds, long-term bonds are more sensitive to inflation expectations in the economy as compared to shorter ones. Hence, the higher the expected inflation, the higher the yields will be as a result of investors demanding commensurate returns to offset inflation. Therefore when the Fed raises interest rates, the yields go up, as investors might be attracted to other risky assets.
• However, when they see the inflation outlook in the long term is stable, they are inclined towards long-term t bonds regardless of modest yields. This drives up the prices of long-term bonds further, thereby constantly reducing the yields.
• Alternatively, as the economy begins to weaken and enters recession, investors are further attracted to long-term treasury bonds to park their money in a haven against falling stock markets. As a direct result of high demand for the longer-term bond, the yields begin to tumble, making the curve inverted.

The yield curve is highly reactive to the state of the economy where it is important to understand the inverted yield curve recession prediction. Usually, long-term bonds offer high yields. However, long-term yields may go down as the general interest rates plummet. Short-term bonds give higher returns than longer-term securities in such downturns regardless of their reinvestment risk.

However, let us understand the situation through some examples.

The yield curve inversion scenario is unwinding in the bond market which is a preeminent and important indicator of coming recession. It has been accounted that the yield of the 10-year Treasury bond is currently below the two-year yield by roughly 0.56 percent.

The US treasury yield is a very dependable benchmark for economic forecast for all investors. There is a good reason behind it. This yield curve inversion has done a perfect recession forecast 10 times since 1955, as per the information revealed by the Federal Reserve Bank.

Let us understand the inverted yield curve investment strategy. An inverted yield hits the debt investors the most. It eats up the risk premium for long-term investors, making them better off in the shorter term. The spread between the treasury and other corporate debts narrows down; therefore, it makes sense to analyze and invest in a bond that offers lesser risk. In such a situation, treasury securities provide similar returns to the junk category, albeit with lower risk.

As the curve inverts, the profit margin for banks and companies, which leverage the near rate by borrowing and then lending for long-term rates, declines. However, surprisingly, inversion also positively affects a few stocks, like those in food, oil, and other consumer durables. Investors tend to attract defensive stocks in case of downturns, which are often the least affected.

The two curves show two different scenarios while establishing the relationship between the the yields of short-trm and long-term bonds. Let us compare them and find the differences.

• The former shows that the shorter term bonds offer higher yields than the longer ones, whereas the latter shows that the longer term bonds offer more yields than the shorter ones.
• The inverted yield curve recession prediction portrays a negative or pessimistic market outlook whereas the latter portrays a positive economic condition.
• The former indicates a low inflation or recession level, whereas the latter suggests higher inflation.
• The former implies that investors are ready to accept lower return on longer term bonds because they are giving more priority to safety of investments, whereas the latter implies that investors want high returns as a compensation for higher risk on long term bonds.
• The graph of the former is flatter or downward sloping, indicating a negative market expectation or potential fall in interest rates or economic weakness, but the latter shows a steeper upward sloping curve indicating a positive expectation of the market regarding rise in interest rates.

However, it is important to understand that the negatively sloping yield curve does not guarantee a inverted yield curve investment strategy but is it a useful predictor as shown in the history or any economy. There may be a difference between the time gap between the curve inversion and actual economic slowdown but it can be used to assess the economic health of a country.

This has been guide to Inverted Yield Curve and its meaning. We explain its causes and its differences with normal yield curve with example and impact. You can learn more about excel modeling from the following articles –

• Meaning of Offset Accounting
• Definition of Phillips Curve
• Calculate Debt Yield Ratio
• Yield Function in Excel