Inverted Yield Curve: Meaning and How it works

The term ‘Yield Curve' basically represent the relationship between long-term and short-term interest rates on securities. The normal yield curve indicates a wide spread between both interest rates, while it is termed ‘inverted' if the spread narrows and the short-term interest rate exceeds the long-term.

inverted yield curve meaning

Historically, an inverted yield curve is an indicator of a potential economic downturn or recession. When the inversion suggests a sentiment that long-term security/investment isn't worthwhile and yield rate offered by long-term fixed investment will continue to fall, investor pull out.

In this article we will explore the meaning of a yield curve, why it occurs, it types, how it is interpreted, what its great importance is and how the markets behave after it.

What does an Inverted Yield Curve mean?

Typically, lending in the long term tends to almost always be a more interesting investment in terms of performance and profitability than short-term lending. Among other reasons because the longer the time passes, the more possibility there is that some negative event will occur.

This is something evident. If we compare 10 and 30 year bonds, no one questions that in a period of 30 years, unfavourable things can happen with a higher statistical probability than in a period of 10 years. For this reason, it is usual that the yield of a 30-year bond is higher than the yield of a 10-year bond.

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An ascending or positive curve occurs in times of economic expansion, with GDP growing, creating jobs and increasing consumer confidence.

That is why it is logical that the yield rate curve has an upward inclination similar to the curve below.

yield curve

When it is said that the inverted yield curve, refers to the fact that the yield of short-term bonds is higher than that of bonds with a longer term. This starts with narrowing of the spread between longer-term and shorter term bonds/securities leading to a flattened curve. The flattened curve then proceeds to an inverted curve when thee short-term yield rate exceeds the long-term yield rates.

The slope of the inverted cure depends on how much the short-term interest rate exceeds the long-term

In these cases, the representation of the inverted curve would be like the one in the following graph.

uk inverted yield curve

In addition, if the yield of bonds of different time periods is identical or very similar, we would have a flat or lateral yield curve, practically linear. In this case, the State pays the same to borrow or ask for money for six months as for ten years. This type of curve is very unusual

Why does the yield curve invert?

As said earlier, an inversion of the yield curve occurs when the yield of short-term bonds is higher than the yield of longer-term bonds.

The reason why the yield curve inverts are simply due to a lack of confidence in the future of the economy, the fact that uncertainty appears, fears, not knowing what is going to happen or fearing the worst (the possible arrival of an economic crisis, a recession, etc).

So, it is a kind of “anomaly” because investors do not have confidence in the economy and demand greater economic compensation from the issuer of public debt in the short term.

Why is an inverted yield curve so important

When an economy facing an inverted yield curve it means there is a lack of confidence in the future that is coming, uncertainty takes over the emotional sentiment of investors.

And it's not for less, because if history has taught us anything over time, it's that the appearance of an inverted yield curve is a quite serious and reliable signal that an approaching arrival of an economic recession of the country in question is near, so it is seen as an increase in the stock market risk.

But regarding this issue, an inverted yield curve presents good news and bad news:

  • The good news is precisely that it is a quite solid tool as a warning or signal that an economic recession is approaching.
  • The bad news is the time that passes between the curve has inverted and the arrival of the recession, since we are talking about one or two years.

In the following graph, we can effectively see that symbiosis that exists between the inverted curve and economic recessions (the thick gray background lines indicate recessions and the blue line that goes up and down is the yield curve).

inverted curve

The most followed yield curve in the world is that of the United States. If you want to follow the curve of Europe, you can do it on the website of the Central European Bank.

At the end of 2022, it was observed that the difference between the yield of the 10-year bond (3.81%) and the 12-month one (4.72%) inverts 91 basis points, quickly approaching a full percentage point. This has only been seen (100 basis points or more) in the summer of 1973 and 1974 and also at the end of 1979-beginning of 1980.

Which Yield Curves are the most important?

Among the different yield curves, we can highlight two as important and relevant:

  • The curve that is established between 3-month bonds and 10-year bonds: the average time from the inversion of the yield curve to the arrival of the recession was one year and seven months.
  • The curve of the 2-year bonds and the 10-year bonds: this differential is surely the best to follow, in fact it is usually the most followed by investors. Suffice it to say that if we take the last five recessions, it proved very useful because it always warned of the arrival of the recession. In this case, the average warning time was one year and nine months, it never dropped below eleven months.

How does the Stock Market behave with an Inversion of the Yield Curve?

One might think that an inverted curve is not a positive fact and therefore would not favour equity markets.

But the reality is quite the opposite. If we take the most important stock index in the world, the S&P 500, we can see that the inversion of the curve not only did not make it fall, but it rose an average of 8% over the next 11 months. Only in one case did the S&P 500 not continue bullish, and that case was in the year 1973.

Another very important issue is which sectors are benefited and which are not. Normally, an inverted curve is followed by a long period of rising rates -by the central bank-. Consequently, it is important to know how interest rates affect stock investments.

Here is a study conducted by Marketwatch that concludes that the S&P 500 on average has risen:

  • A 2.5% during the 3 months following an inverted curve.
  • 6 months later the rise tends to be 4.87%,
  • 12 months later it rises to 13.5%,
  • 24 months later 15%
  • And 36 months later 16.4%.
yield curve us

In this chart, we can see the average annual return of the main assets (US stock market, world stock market, commodities, gold) after the inverted curve between the years 1978 and 2008.

In conclusion, an inverted yield curve, warns -and with quite accuracy-of the risk of stagnation and even medium-term recession. However, it is accompanied by rises in the stock market, as markets begin to discount how much it will rise, once the stage of economic recession passes.

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FAQs about Inverted Yield Curve

What is a Yield Curve?

It is a structure of interest rate that shows the return on bond/securities over different periods ranging from short-term to long-terms. It indicates the left side as the short-term yield and the right side as the long term return.

What can an Inverted Yield Curve tell an investor?

Historial progression tells that that a inverted yield curve in any economy precedes recession as seen in the United States. The inverted curve reflects investors expectations for a decline in longer-term interest as a result of bad economy.

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