What is an “inverted yield curve” and why are people talking about it?

An “inverted yield curve” isn’t a weather phenomenon. Nor is it a unique turn in a roadway. But it may provide an indicator for economic issues to come.

The Treasury yield curve provides signals to economists on investor behaviors.

Normally, investors get a higher rate of return if the investment product they are buying comes due, or matures, further into the future. For example, at most U.S. banks, investing in a 2-year certificate of deposit yields more returns than investing in a three-month one.

The U.S. government, like your local bank, sells a wide variety of debt products with varying maturities: under 1-year (called Treasury Bills), 2-year to 10-year (called Treasury Notes), and 30-year product lifecycles (called Treasury Bonds), meaning that investors are agreeing to give the U.S. government their money for a specified amount of time before getting it back upon “maturity” and with interest.

Visually, lining up yields or what the government pays an investor on Treasury securities, produces a line that is curved describing what investors get in return for lending the U.S. government money.

In August 2019, for the first time since before The Great Recession, the rate of return on a 2-year Treasury Note has exceeded the rate of return on a 10-year Treasury Note.

This situation produces an “inverted” yield curve (as seen below). This type of curve has preceded all recent recessions.

There’s a simpler way to look at this too. When the 10-year yield is higher than the 2-year yield, the curve is normal. When the 10-year yield is lower than the 2-year yield, the curve is inverted.

Economists at the Federal Reserve Bank of Chicago, have noted that “the yield-curve slope becomes negative before each economic recession since the 1970s.”

But those same economists don’t guarantee a decline in the economy. The Chicago economists also write that “not all declines in the yield-curve slope are bad news for the economy, and not all instances of steepening are good news either… empirical results we have described in this article do not imply that a yield-curve inversion causes a recession. Rather, it could be that the slope itself fluctuates to reflect changing expectations about the economy, and these expectations are useful predictors of economic downturns.”

In other words, the yield curve is looked at by economists as a useful indicator about changing economic expectations, but not a failsafe predictor of which way the economy will go.

The Treasury’s yield curve rates change daily and you can compare rates for various maturity dates here.

Source: US Treasury