An Inverted Yield Curve describes the appearance of the yield curve where interest rates on the longer end drop below interest rates on the shorter end. Oftentimes, but not always, an inverted yield curve portends a recession. The reason this occurs is that when the market believes interest rates over a longer period of time will be lower versus interest rates more close to the present time. From a visual standpoint, the inverted yield curve shows the longer end sloping downward and lower versus the shorter end of the yield curve. If you are wanting to learn how to invest in stocks, understanding the yield curve and the variations of the yield curve will help you to learn how to analyze stocks.
What is the Yield Curve?
The first thing to understand is: What is the yield curve. It is a visual representation of yields on the same quality of debt instruments over many different maturity dates. The United States Treasury reports its daily yields for the various maturities. The information in these charts are from the Treasury Yield data.
In the above chart you can see the maturities for all of the various dates over the course of time. This is from 06/23/2006. This is the last “normalized” yield curve the US economy has experienced in many years.
The above chart is in bar format. During the 1970s, financial professionals realized you could convert this into a line chart. And, after doing that, the financial professionals found the visual was easy to interpret.
The above line chart is the exact same chart at the above bar chart. From a visual standpoint, examining the yield curve using a line chart allows for easier interpretation.
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What is an inverted Yield Curve?
As mentioned, an inverted yield curve would have interest rates that are lower in more distant maturities versus near-term maturities.
The above yield curve, just 2 months after the previous normalized yield curve, was a signal of financial change was imminent. In this case, the inverted yield curve was detailing the housing crisis was looming.
In the case of the 2008 housing crisis, mortgage holders were starting to feel the strains of the balloon mortgage rates. Because of this, longer-dated interest rates began to fall. This is owed to the fact that long-term bond issuers were taking on less risk. As there was less supply, prices rose for what supply existed. The inverse relationship between price and yield for interest rates drove prices upward and yield on longer end maturities began moving lower.
What does an Inverted Yield Curve Tell Investors?
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If you can glean from the interest rates that bond issuers are not supplying as much debt, and subsequently there is a push upward in price of what debt is being issued, the visual representation of the yield curve will show the longer maturity dates are dropping relative to shorter-dated debt instruments.
An investor would want to understand what is happening in the longer dated maturities and ask the question why debt issuers are not offering more debt; why these debt issuers are taking on less risk.
If, in fact, the yield curve is showing that there is a significant shift in risk appetite, a recession may be looming. And, investors would need to be cautious in the future.