Here's Why You Should Care About an Inverted Yield Curve

If you’re wondering what a yield curve is and why there’s so much fretting about a looming recession, here’s what the fuss is all about

A yield curve is a way to show the difference in the compensation investors are getting for choosing to buy shorter- versus longer-term debt. Most of the time, they demand more for locking away their money for longer periods, with the greater uncertainty that brings. So yield curves usually slope upward.

A yield curve goes flat when the premium, or spread, for longer-term bonds drops to zero -- when, for example, the rate on 30-year bonds is no different than the rate on two-year notes. If the spread turns negative, the curve is considered “inverted.”

The yield curve has historically reflected the market’s sense of the economy, particularly about inflation. Investors who think inflation will increase typically demand higher yields to offset its effect. Because inflation usually comes from strong economic growth, a sharply upward-sloping yield curve generally means that investors have rosy expectations. An inverted yield curve, by contrast, has been a reliable indicator of impending economic slumps, like the one that started in 2007. In particular, the spread between three-month bills and 10-year Treasuries has inverted before each of the past seven U.S. recessions.

Since late in 2018, markets have been concerned about the possibility of a global economic slowdown, fed in part by the trade war between the U.S. and China. Those signs of weakness led the U.S. Federal Reserve first to pause the series of interest rate hikes it had been pursuing and then to cut rates in July. At the same time, however, the Fed signaled that the cut wasn’t necessarily the start of a cycle of rate reductions. That statement kept yields on shorter-term debt anchored, while concern over the economy sent investors scrambling for the safety of long-dated Treasuries. That dropped U.S. 10-year yields below that of two-year Treasuries, while 30-year yields fell to a record low. In the U.K., 10-year yields dropped below that of two-year bonds. At the same time, Germany’s yield curve reached its flattest point since the financial crisis.

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