Investopedia/James Chen: What is an Inverted Yield Curve?

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Investing Bonds / Fixed Income

Inverted Yield Curve
Reviewed by James Chen
Updated Mar 22, 2019
#Inverted Yield Curve
What is an Inverted Yield Curve?

An inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.

A partial inversion occurs when only some of the short-term Treasuries (five or 10 years) have higher yields than 30-year Treasuries. An inverted yield curve is sometimes referred to as a negative yield curve.

Historically, inversions of the yield curve have preceded many of the U.S. recessions. Due to this historical correlation, the yield curve is often seen as an accurate forecast of the turning points of the business cycle. A recent example is when the U.S. Treasury yield curve inverted in late 2005, 2006, and again in 2007 before U.S. equity markets collapsed. The curve also inverted in late 2018. An inverse yield curve predicts lower interest rates in the future as longer-term bonds are demanded, sending the yields down.
Inverted Yield Curve
Yield and Maturity

Yields are normally higher on fixed-income securities with longer maturity dates. Higher yields on longer-term securities are a result of maturity risk premium because changes in the value of longer-term securities are more unpredictable with market interest rates potentially more unsettled over a longer time horizon. However, yields on longer-term securities could be trending down when market interest rates are set to get lower for a foreseeable future to accommodate ongoing weak economic activities. Irrespective of their reinvestment rate risk, shorter-term securities appear to offer higher returns than longer-term securities during such times.
Yield and the Economy

The shape of the yield curve changes in accordance with the state of the economy. The normal or up-sloped yield curve may persist when the economy is growing and conversely, the inverted or down-sloped yield curve is likely to press on when the economy is in a recession. One underlying reason such a relationship exists between the yield curve and economic performance relates to how a higher or lower level of long-term capital investments may help stimulate or rein in the economy. By issuing longer-term securities with lower-yield offerings, businesses and governments alike can acquire needed investment capital at affordable costs to jump start a weak economy.
Yield and Bond Demand

What moves yields in the market is the varying demands for securities of different maturities at a particular time and under given economic conditions. When the economy is heading to a recession, knowing interest rates are to trend lower, investors are more willing to invest in longer-term securities immediately to lock in current higher yields. This, in turn, increases the demand for longer-term securities, boosting their prices and further lowering their yields. Meanwhile, few investors want to invest in shorter-term securities when presented with lower reinvestment rates. With lower demand for shorter-term securities, their yields actually go up, giving rise to an inverted yield curve when yields on longer-term securities have come down at the same time.
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Related Terms
Yield Curve
A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.
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Normal Yield Curve
The normal yield curve is a yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality.
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What is Yield Curve Risk?
The yield curve risk is the risk of experiencing an adverse shift in market interest rates associated with investing in a fixed income instrument.
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Humped Yield Curve
A humped yield curve is a relatively rare type of yield curve that results when the interest rates on medium-term fixed income securities are higher than the rates of both long and short-term instruments.
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On-The-Run Treasury Yield Curve
The on-the-run Treasury yield curve is derived from on-the-run U.S. Treasuries and is the primary benchmark used in pricing fixed-income securities.
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Riding the Yield Curve
Riding the Yield Curve is a trading strategy that involves buying a long-term bond and selling it before it matures so as to profit from the declining yield that occurs over the life of a bond.
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