What Is an Inverted Yield Curve?

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An inverted yield curve, sometimes referred to as a negative yield curve, is an unusual drop of longer-term debt yields below the shorter-term debt yields of the same credit quality. It is unusual because the expectation for a debt investor, such as a bond investor, is to witness higher yields over a longer period than a shorter period. When the yield curve inverts, it reflects bond investors’ expectations for a decline in longer-term interest rates, typically indicating a recession in the near future.

To better understand an inverted yield curve, let us go over what a yield curve is. A yield curve is a graphical representation of the yields of similar debts across a variety of maturities. The following image is the typical representation of a yield curve courtesy of Investopedia, where yields increase over a longer maturity period:

An inverted yield curve instead slopes downward and means that shorter-term interest rates have exceeded longer-term interest rates, depicted by the following image courtesy of Investopedia:

The 10-year and 2-year treasury yield spread have been used as a relatively reliable recession indicator since the mid-1960s. For example, on August 28th, 2019, the 10-year and 2-year spread briefly went negative. A brief recession followed in February and March of 2020 amid the outbreak of the COVID-19 pandemic. The brief recession could have happened regardless of the yield curve inverting in August 2019, which showcases why the inverted yield curve is just considered relatively reliable.

On April 1st, 2022, the 10-year and 2-year spread inverted again for the first time since 2019. This has led to the belief that a recession could be coming soon. With the stock market having one of its worst starts to the year since 1939 and inflation rising 8.5% over the last 12 months, there is some indication of a recession likely occurring in the near future. No indicator will ever predict the future 100% correct, but it does help paint the picture of what can come. Do you think we will have a recession within the next one or two years? Let me know in the comments.