What You Should Know About the Inverted Yield Curve and Economic Trouble

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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: 

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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.

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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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Last updated: May 19, 2021