Inverted Yield Curve Meaning How Inverted Yield Predicts Recession

Inverted Yield Curve Meaning

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.

What’s a Normal Yield Curve?

The normal yield curveYield CurveA yield curve is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis). The slope of the yield curve provides an estimate of expected interest rate fluctuations in the future and the level of economic activity. read more 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 curveA Positive Yield CurveA normal yield curve refers to a positive yield curve formed when the long-term debt instruments provide greater returns when compared to the short-term debt instruments when both these options possess equivalent credit risk and quality.read more.

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Why the Curve Becomes Inverted?

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 inflationExpected InflationInflation expectations refer to the opinion on the future inflation rate from different sections of the society, such as investors, bankers, central banks, workers, and business owners. As a result, they take this rate into account when making decisions about various economic activities they want to engage in in the future.read more, 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 bondsTreasury BondsA Treasury Bond (or T-bond) is a government debt security with a fixed rate of return and relatively low risk, as issued by the US government. You can buy treasury bonds directly from the US Treasury or through a bank, broker, or mutual fund company.read more 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.

How does the Inverted Yield Curve Affect Investments?

An inverted yield hits the debt investors the most. It eats up the risk premiumRisk PremiumRisk Premium, also known as Default Risk Premium, is the expected rate of return that the investors receive for their high-risk investment. You can calculate it by deducting the Risk-Free Investment Return from the Actual Investment Return. read more 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 marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more 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 stocksDefensive StocksA Defensive Stock is a stock that provides steady growth and earnings to the investors in the form of dividends irrespective of the state of the economy as it has a low correlation with the overall stock market/economy and is therefore insulated from changing business cycles.read more in case of downturns, which are often the least affected.

Important Note

The yield curve is highly reactive to the state of the economy. 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.

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 investmentsThe Major Causes Of This Co-relation Is How The Market Players Think The Capital InvestmentsCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more are going to weigh in on the oncoming economic changes or stimulate the economy as a whole.

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. And as the demand for short-term securities goes down, their yields increase.

Bottom Line

Inverted curves are 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.

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.