If you follow the markets closely, you have likely heard of the infamous “inverted yield curve.” Many experts on CNBC may link this flip to a coming recession, or a bear market. The stock market responds to the news of the curve reversal with strong selling. Today, the indicator has just made its presence known again, and the market did in fact sell off, with the S&P 500 down 1.90%, the Dow Jones down 1.77% and the Nasdaq down 2.50%. All this occurred despite a massive rally since the 20%+ sell-off that carried into the end of December. The interest rate for the 90-day T-bill surpassed that of the 10-year Treasury debt security, the benchmark inversion. But is the inverted yield curve really a cause for worry?

NOTE: To understand the terminology in this lesson, you will likely want to understand bonds and U.S. Treasuries, so please read our lessons here and here

What is the yield curve? What does it mean when it inverts?

The yield curve displays various interest rates, or yields, associated with different length debt securities, such as Treasury securities or bonds, though “the yield curve” likely refers to the Treasury yield curve for Treasury securities. As you can see in the graph below, higher borrowing periods are associated with higher yields, or interest rates. This is because of something called Maturity Risk Premium, and according to the Motley Fool, it exists because “one of the dangers of investing in a long-term bond is the potential for it to lose value before it comes due.” If interest rates increase, for example, then the value of your debt security, such as your bond, will decrease. When purchasing a bond for a longer amount of time, you incur more risk of your security decreasing in value. Hence, the increasing nature of the yield curve.

In times of economic growth and a stable stock market, the yield curve and the bond market as a whole will be stable and “normal.” Returns in the stock market will be higher than those from bonds, so demand for bonds will be relatively minimal. However, what happens in a bear market is the exact opposite.

The yield curve can invert in a bear market. This is because the demand for safer, Treasury securities, which are safe and offer consistent returns through their yields, increases in bear markets. With this higher demand, the price of bonds increases, and accordingly, their interest rates decrease. The demand for short-term debt securities and Treasury securities, however, is not as strong in recessions. Thus, the interest rates for those short-term securities will rise. As a result, the inverted yield curve, as seen below.

You may commonly hear of the curve “flattening.” This, in effect, is a more moderate transition away from the normal, upward-sloping curve to a flat curve, in which the interest rates are very similar or the same for various maturity dates. Often, this flattening is the first step towards an inverted curve, as the inversion of the yield curve is often years in the making.

What does the inverted curve mean?

The true significance of the inverted yield curve has been of considerable debate for the past few years. The curve has flipped a few times in the past few years, yet the economy has continued its bull run. Some economists defend the inverted curve as a signal for a looming recession, that has proved itself many times. Others ignore its presence, citing strong growth prospects and corporate earnings in an economy. It cannot be ignored that the historical track record of the inverted yield curve is quite strong, accurately predicting the latest recession in 2008, and many prior to that.

In the global economy, there are some fears of economic downturn. Growth has been greatly slowed by the trade war, corporate earnings have been some of the worst in a while this year in Q1 of 2019, and political tension remains a potent force in the European Union. An inverted yield curve simply continues to increase investor fear, and increases expectations of a recession. The “fear index,” or the CBOE Volatility Index, spiked by 20.91% today.

Final Thoughts

The inverted yield curve is a good metric to use when predicting recessions, but it is not the only metric one should rely on. As with all occurrences in the economy, more context is needed to analyze and predict the future. If the curve inverts in a strong economy, then you can expect the curve to recover back to normal. But if conditions appear to be turning for the worse, an inverted yield curve can often confirm fears of bear markets in the future. As with all economic indicators, use the yield curve with a great understanding of underlying market conditions.

Data from finance.yahoo.com

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