Inverted yield curves happen when bonds with shorter maturity periods have higher yields than bonds with longer maturity periods. Under normal circumstances, it’s the other way around. Since longer-term debt carries greater risk than shorter-term debt, bonds with longer durations naturally have higher yields. Check any bank’s website and you’ll see that six-month CDs pay lower rates than CDs that require you to part with your money for two years.
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Inverted yield curves are remarkable and thankfully rare events. They’re important because they serve as one of the most reliable predictors of economic trouble on the horizon.
Inverted Treasury Yield Curves Can Be Recession Early Warning Systems
Economists pay extra close attention to inverted yield curves when they happen with Treasury bonds, notes, or bills. That’s because short-term Treasury yields track the all-important fed funds rate, which is the interest rate that banks charge other banks to borrow their excess cash.
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Here’s why that’s important:
- When the yield curve inverts, it’s because investors think that their money will be safer with long-term Treasurys than they would with short-term Treasurys.
- That’s because the Federal Reserve lowers the fed funds rate when the economy stalls.
- If investors buy short-term Treasurys when the economy is stalling, those bonds will mature and force their holders to reinvest that money during an economic downturn.
- That — coupled with the fact that investors expect short-term Treasury yields to collapse during a recession — sends demand for long-term Treasurys soaring.
- A boom in demand causes long-term Treasury yields to fall.
- Just as long-term yields are falling, short-term Treasurys respond to a drop in demand by raising their own yields. Eventually, short-term yields climb so high and long-term yields fall so low, that the curve inverts.
It’s All Very Complicated, But It’s Also Quite Simple
If you’re new to this subject matter, that’s a lot to take in, but remember the following:
- Yields should be higher for long-term Treasurys than for short-term Treasurys.
- When they switch, it’s because investors don’t have confidence in the economy’s near-term prospects.
- When demand for long-term bonds gets so high that the yield curve inverts, a recession is likely.
Historically, Inverted Yield Curves Are Excellent Oracles
The economy moves between periods of growth and recession. An inverted yield curve has preceded every single recession since 1956, according to CNBC. That’s 11 recessions out of 11, according to Forbes. In that time, there has been only one false positive, which makes the inverted yield curve one of the most predictably accurate indicators of an impending recession. It’s important to note that inverted yield curves are leading indicators. The recessions that tend to follow them usually don’t arrive for months or even years after the curve inverts.
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An inversion preceded the bursting of the tech bubble in 2001. The next one came in 2005. Two years later in 2007, a recession set in just before the financial crisis shook the world in 2008.
Most recently, the yield curve inverted briefly in March 2019. The Fed responded, according to Forbes, by slashing rates. That action might have helped avert — or at least delay — an impending recession. About a year later in February 2020, the yield curve briefly inverted again, which makes many of today’s top economists uneasy, to say the least.
This article is part of GOBankingRates’ ‘Economy Explained’ series to help readers navigate the complexities of our financial system.
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