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What Is a Yield Curve?
A yield curve refers to a chart that plots the yields for debt securities of various terms. When investors reference the yield curve, they are typically speaking about the yields for U.S. Government Treasuries, although yield curves can be presented for foreign government debt and corporate debt.
What Is a Normal Yield Curve?
Normally, debt securities with longer terms carry a higher yield (~higher interest) than debt securities of shorter terms. This reflects the added risk of holding debt securities for longer periods of time.
If investors could earn, for example, 3.5% on a 1-year treasury, or the same annualized 3.5% yield on a 30-year treasury bond, there's usually little incentive for investors to put their money away for the longer term. They could simply invest for one year at 3.5%, and, if they choose, invest for another year at 3.5% after that (assuming interest rates haven't shifted in the meantime). An investor could rollover their investment each year for 30 years instead of locking thei funds away for 30 years right at the start.
Effectively, therefore, investors commonly demand a premium to commit to investments that are longer in term. This is referred to as liquidity preference.
As a result, under normal financial market conditions, the yield curve is upward sloping.
What Is an Inverted Yield Curve?
On the infrequent occasions when the yields on longer duration instruments are lower than those of short maturities, the yield curve slopes downward and is said to be "inverted".
It's important to understand that the shape and slope of the yield curve is driven by investor demand. If investor demand for 30-year U.S. Treasury Bonds increases, this will push down the 30-year yield. If investor demand for U.S. T-bills declines, t-bill yields will rise. If there's a big enough shift in demand from short-term debt securities to long-term debt securities, the yield curve can invert.
An inverted yield curve can signal investor concern over the economy. In these cases, investors are actively storing their cash in safe long-term U.S. Treasuries and are less concerned about the opportunity cost of doing so.
While the yield curve can take various forms, financial participants conventionally refer to to the spread between 2-year Treasuries and 10-year Treasuries in defining whether an inverted yield curve is in place.
Yield Curve Movement
The Federal Reserve generally guides short-term interest rates via monetary policy, but long-term interest rates and yields are determined almost exclusively by markets participants. The market will normally price longer-term bonds to yield more than shorter-term bonds to compensate investors with greater returns for taking longer risks.
When investors are nervous about the possibility of economic weakness and a stock market decline, many will look to purchase longer-term debt such as U.S. Treasury bonds as a haven, even if they have low yields. The thinking is that a low yield on a Treasury bond is better than losing money in riskier investments during an economic downturn.
Downward Sloping Yield Curve
A downward-sloping yield curve is another way to describe an invested yield curve. In cases like this, the short-term maturities carry a higher yield than longer-term maturities.
Inverted Yield Curves as Recession Indicator
An inverted yield curve is typically driven by investor concerns about the economy (as well as concerns about stock market investments). History suggests that a inverted yield curves are a great predictor for economic weakness. Since WWII, every economic recession has been preceded by a yield curve inversion. In some cases, however, the yield curve has inverted without a near-term economic recession.
Recessions have tended to lag yield curve invesions by 6 to 18 months.
Inverted Yield Curves from Recent History
currentmarketvaluation.com
Source: Yield Curve Indicates Stock Market is Fairly Valued
From this chart, one can see that the recessions of 2020, 2009, 2001, and all others back to 1960 were preceded by yield curve inversions.
2022 Inverted Yield Curve
In March of 2022, the 2-year Treasury yield and the 10-year Treasury yield officially inverted for the first time since 2019. As of March 2023, the yield curve remains invested. Based upon 50 years of history, this yield curve inversion signals risk of a recession by 2024.
Bottom Line
The yield curve reflects the yield investors demand for debt securities of various maturities. A normal yield curve is upward sloping, and reflects the theory of liquidity preference. When the yield curve becomes downward sloping, it is said to have inverted. An inverted yield curve reflects a deterioration in investor sentiment regarding the economy and riskier investment opportunities. In many cases, an invested yield curve is followed by an economic recession.
