What's an Inverted Yield Curve

I wanted to take this week’s column to talk about a topic people bring up a lot, but many people wonder what exactly does it mean.  I’m talking about a yield curve, specifically an inverted yield curve.  Why?  Well, because you are now going to start hearing lots about inverted yield curves and recessions.

Let’s begin with some background.  The Yield Curve is when the yield of a longer-term bond is higher than a short-term bond.  As a reminder, think of yield as a dividend or a regular payment you receive from an investment.  In this case it applies to a bond.  

I am going to keep things simple in this example.  Let’s say the yield on a 10-year, $10,000 bond is 4%.  So, its annual yield is $400.  For a 3-month bond, the yield is usually much lower.  Say 2%.  So, this bond may have an annual yield of $200.  There is less risk with the shorter-term bond so it pays less. If you were to chart this example you would get a normal yield curve.  On the chart the curve would move up and to the right.  

An inverted yield curve is when the yield on the longer-term bond is lower than the shorter-term bond.   A simple example would be the yield on the 10-year may be 2%, but the yield for the 3-month might be 2.5%.  On a chart the curve would move down and to the right to show the inversion.

What causes this?   Well, when investors think stocks are going down they make a shift to more secure investments.  This can include moving to longer-term bonds.   When more people buy these bonds the prices go up and the yields go down (bond prices and yields are like two ends of a teeter-totter).  If there is enough demand, the yields on the longer-term bonds will drop below those of the shorter bonds.  And then the yield curve inverts.

Inverted yield curves get a lot of attention and for good reason.  The last seven recessions were preceded by an inverted yield curve.  If you want to track the data on yield curves I would recommended the New York Fed website for great data.  Oh, and you are probably wondering if we are presently in an inverted yield curve environment.  The answer is we have been in one for a few months.  Just because the yield curve inverts doesn’t mean we are in or nearing a recession, however, there is definitely a connection.  But never forget the joke that economists have predicted 12 of the last 7 recessions.

Finally, here is a recent video I recorded on this same topic.  Feel free to share if someone starts asking about inverted yield curves and recessions.