The Impact of an Inverted Yield Curve

The link between the short- and long-term interest rates of fixed-income securities issued by the U.S. Treasury is known as the yield curve. When short-term interest rates are higher than long-term interest rates, the yield curve is inverted. Since debt with longer maturities often carries higher interest rates than debt with shorter maturities, the yield curve is normally not inverted.

An inverted yield curve is a notable and unusual economic occurrence since it indicates that the short term is riskier than the long term. In the sections that follow, we’ll explain this unusual phenomenon, go over how it affects consumers and investors, and show you how to modify your portfolio to consider it. From the inverted yield curve you can get a sign of pending recession too.

WHAT IS AN INVERTED YIELD CURVE?

Longer duration fixed income assets often have greater interest rates than shorter-term securities. The additional risk of time is explained by this. The yield curve slopes downward and is referred to as being “inverted” in the rare instances when the yields on longer duration instruments are lower than those of durations.

As duration lengthens, the yield curve—a depiction of the yields for various durations of the same instrument—typically slopes upward. It’s not because the issuers of recently issued longer-dated bonds abruptly reduce the coupons short that the curve inverts. It’s because supply and demand forces lead bonds’ prices to rise or fall, which in turn causes their effective yields to do the same. Instead of actual coupons, the yield curve displays these effective yields.

As a result, the price of long-dated bonds increases, and the effective yields decrease when there is a significant demand for them. They can become less expensive than shorter-term bonds when demand is sufficiently strong and yields decline sufficiently. This often happens just once every ten years or so, and it indicates investor worries about the economy.

WHAT DOES IT MEAN WHEN A YIELD CURVE INVERTS?

A 10-year bond, for example, will have a lower annual yield than a 3-month bond when the yield curve inverts. This indicates that longer-dated bonds’ prices have been driven up by investors to the point that they now yield less than short-term bonds.

INVERTED YIELD CURVES AS RECESSION INDICATOR

Investor worries about the economy and the stock market lead to an inverted yield curve. History demonstrates that when the yield curve is inverted, investors frequently predict impending economic deterioration correctly. Since World War II, a yield curve inversion has come before every recession.

However, recessions don’t begin right away after the yield curve inverts. The inversion often occurs six to eighteen months before the recession.

INVERTED YIELD CURVE FOR 2022

The 2-year Treasury yield and the 10-year Treasury yield flipped for the first time since 2019 on March 31, 2022. On March 29, 2022, the yield curve briefly reversed, albeit only briefly. The 2022 yield curve inversion predicts a recession by 2024 based on 50 years of data.

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