What Does An Inverted Yield Curve Mean?

You’ve probably been hearing some news lately about how the yield curve has gone inverted recently. You man be wondering, “What is an inverted yield curve? And why does that matter to me?” These are two great questions, and important ones too!

Check out this really cool video of the history of the treasury yield curve from 1990-2018.

After you read this post you’ll probably want to go back and watch this again and notice when the yield curve flattens out and inverts.

Interest rates are usually usually a pretty good indicator of how the economy is doing, and can many times tell you the direction that it’s heading. In fact, the yield curve is a much better indicator of the economy than stock market prices are.

A normal interest rate yield curve slopes up and to the right. In other words, short term interest rates are normally lower than longer term rates. This is true whether you’re investing money or borrowing money. If you think about investing in bank CD’s, a 2-month CD will normally pay you less interest than a 5-year CD. When you buy a CD you’re basically letting the bank keep your money for that period of time. The longer you let them keep it, the more they have to pay you for it.

The same concept applies to borrowing money, like on a mortgage. Mortgage interest rates for a 15-year mortgage are normally lower than what you’d get on a 30-year mortgage. A bank is taking more risk to let you borrow money for 30 years compared to letting you borrow it for 15 years. So they charge you more for a 30 year mortgage.

So what does all this have to do with a yield curve inversion? OK, I’m getting to that! Interest rates are affected in part by supply and demand. When a lot of people want to buy a certain bond, that drives the price of that bond up, and at the same time it makes the yield or the interest rate of that bond go down. If you have a lot of demand out there for the 10-year bond for example, the price of that bond goes higher, and the interest rate on it goes lower. At the same time, if you have less demand for a short term-bond, the value of that bond will go down and the interest rate on it will go higher.

When a yield curve inverts, it means that more people are buying the longer term bonds, and selling the shorter term bonds. Investors would do this if they felt like a recession may be coming and so they want to lock in their money at higher, longer term rates. They do this for a few reasons. First, to protect their money in case the recession does come. And second, in a recession the Fed normally lowers short term interest rates. If your money is all invested in short term rates and the Fed starts lowering them, you’re going to get less and less interest and wish you had locked in a longer term rate earlier.

Historically, the treasury yield curve always goes inverted along with a recession starting. The most reliable rates to look at for an inverted yield curve are the 2-year and 10-year treasury yields. There’s only been one time in history that a recession started before the 2-year yield went higher than the 10-year yield. Normally, the two will invert about 18-24 months before the recession starts. Right now, the 1-month through the 6-month yields are higher than the 10 year yield. This is why you may have been hearing about an inverted yield curve lately. But, the 2-year treasury yield is still lower than the 10-year yield. Watch the video again and notice the times when the yield curve what flat and inverted. There was a recession that started July of 1990, so the video starts out with a pretty flat curve. The next recession started March 2001. And the last one started December of 2007.

I don’t think this is an emergency alarm going off yet, but it’s definitely something to be aware of and to watch closely. The next few years could bring more new highs in the stock market, or it could be a painful slogging with not much to show. It’s impossible to say this early after a yield curve inversion. However, we just recently had the 10-year anniversary of the stock market hitting it’s low point in March of 2009 at the end of the last big correction. Our economy has been recovering since then, which is a very long time for a recovery.

I’d love to hear your comments on this subject. Let me know what you think.

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