An inverted yield curve occurs when short-term bonds yield less than long-term bonds. It’s unusual because that’s exactly opposite of what normally occurs in the bond market. It’s significant because it predicts a recession. Being able to identify an inverted yield curve allows you to avoid and/or minimize bad decisions.
Inverted Yield Curve Explained
To understand the inverted yield curve, you need to understand bonds. Simply stated, bonds are a loan you make to the bank. The bank repays your loan along with a fixed amount of interest. So, if you buy a two-year bond for $100 with a 2% annual rate of return, then the bank pays you $104.04 after two years.
Although it’s a low return, bonds have several perks that justify the small rate of return:
- Stability: The only way you lose money with a bond is if the U.S. government defaults on its loans. This has never happened.
- Guaranteed Return: You know exactly what your ROI is on any bond(s) you purchase.
- Longer Investments Mean Higher Returns: While there are a few exceptions, your return is usually higher when you invest for longer periods of time.
When people talk about an inverted yield curve, it usually refers to bonds guaranteed by the U.S. government.
The graphs below show bond yields based on maturity. The graph on the left is typical. It shows older bonds providing higher interest rates. The graph on the right is opposite and shows younger bonds providing higher interest rates. This shows a lack of investor confidence in older bonds. It’s also a sign that recession is coming.
How Does It Happen?
The fear of loss is a great motivator. When faced with the possibility of losing money, people get scared. When we get scared, we tend to make decisions we wouldn’t normally make. As a recession approaches, people try to avoid loss by investing in long-term U.S. Treasury bonds. Because they know interest rates on stock will drop, they may also move investments from stocks to bonds.
It’s the law of supply and demand in action. Because people are buying up long-term bonds, the Federal Reserve makes them less attractive and lowers rates. Likewise, the Fed wants to make short-term bonds more appealing, so they increase rates. This results in an inverted yield curve.
What You Can Do
We are neither in a recession, nor experiencing an inverted yield curve at the moment. However, if/when you’re facing any outside situation that affects you, remember to focus on what you can control and let go of what you can’t control. When it comes to your finances, it’s a good idea to get your financial house in order. Preparing today for things beyond your control in the future, gives you the best chance of coming through successfully.