Inverted Yield Curve Explained

Inverted Yield Curve Explained

Graphs can reveal trends in the performance of financial instruments like bonds. The inverted yield curve is one such projection that provides indications about the performance of certain investments.
WealthHow Staff
Certain financial parameters can be used to determine the health of a nation's economy. There are several theoretical constructs in economics, that help us understand the nature of any economy. One such construct is an 'Inverted Yield Curve'. What this curve means and what is its significance, is the subject matter of this article. If you are studying economics, this is a concept which you have to know as it is supposed to have a connection with the onset of an economic recession.

To understand the nature of change in any system, you need to study the relationship between various factors which drive that change. In the case of an economy, what matters is the yield that people draw from long-term and short-term investments.

What is a Yield Curve?

A yield curve is a graph of yield drawn from a bond investment or other such securities, against the maturity period for the bond. The yield drawn from a bond or security investment is directly proportional to the interest rates offered on them. The curve which is traditionally studied as an economic health indicator in USA, is the one showing change of yield against US treasury debt maturity period, which extends up to 30 years.

Definition

When the yield from short-term investments becomes higher than yield from long-term ones, the two-dimensional graph drawn, with yield on Y-axis and maturity on X-axis shows an inverted nature. The investments we are talking about here are securities issued by the US treasury itself, which are treasury bond investments. This is what is known as an inverted yield curve.

In this situation, the interest drawn on short-term investments is higher than the interest drawn on long-term ones. Normally, in times of positive economic growth, the situation is reverse. That is, long-term investment yields (and interest rates) are greater than short-term yields. Let us see what is the significance of an inverted economic curve, with regards to the nature of an economy.

Significance of the Concept

It is a fact of observation that a real world economy rarely finds itself in an inverted yield phase. However, when this kind of nature of the curve shows itself, the economic growth tends to slow down. As history has shown us, just before the US economy plunged into a recession, there has been an inversion of the yield curve. That is why, it is a phenomenon that is watched out for.

It means that any common investor prefers a long-term investment, despite a high interest rate of return on short-term instruments, because he doesn't have faith in the economy at the present moment. It is an indicator of diminishing optimism of the consumer in the current state of an economy.

The fear of a recession prevents them from investing in short-term bonds with higher returns as they think that their inherent value will diminish shortly. They would rather prefer that their money stays invested for the long term.

Every economic recession has been mostly preceded by an inverted yield curve, which shows the relationship of yield with maturity period of any investment. Hence, it is considered as an indicator of economic recession and changes in it are therefore, scrutinized by economists.