An inverted yield curve is when yields on short-term bonds are higher than the yields on long-term bonds. When U.S. Treasury bonds invert, it usually indicates a recession is coming.
Normally short-term bonds have a lower yield than long-term bonds. Having your money held for a shorter amount of time brings a lower return. Buying long-term bonds means you will hold them longer in exchange for a better return. This is when the yield curve is normal, the returns are opposite during a yield inversion.
The yield curve inverts when investors flock to long-term bonds. Investors will prefer long-term bonds when they believe the economy will fall in the short term.
The high demand for long-term bonds pushes the bond prices higher and lowers the yields. The low demand for short-term bonds decreases prices and increases yields.
What Does an Inverted Yield Curve Mean?
Simply put an inverted yield curve means investors believe their money is better off in longer-term bonds than short ones.
When a recession comes, the value of short-term bonds will drop so it makes better sense to buy long-term bonds. This is because the Federal Reserve lowers rates during recessions and short-term treasuries will follow.
The U.S. Treasury sells treasury bills, bonds, and notes in 12 different maturities.
• 1-month, 2-month, 3-month, and 6-month bills
• 1-year, 2-year, 3-year, 5-year, and 10-year notes
• 30-year bonds
The most worrying inversion is when 10-year treasury yields drop lower than 2-year yields.
The 2- and 10-year treasury yield inversion is considered a reliable recession indicator for the U.S. economy. The 2-10 yield inversion has happened before every recession since 1950. This includes 1981, 1991, 2001 and 2008 recessions.
The issue with using inverted yields to predict a recession is that it can take 34 months or possibly longer before a recession hits. While the market will sell-off on the day it happens, markets have historically continued to rally after the initial inversion.
Investors fear the recession when yields invert but tend to forget about it a year or so down the road when the market is rallying. That’s usually when a recession comes and markets drop. An inverted yield curve should be taken seriously. However, it’s nearly impossible to predict exactly when a recession will come.
The chart above highlights the times’ yields have inverted prior to a recession.
February 2, 2000, it took 12 months before the recession hit. June 8th, 2006, it took 17 months before the recession hit. Recently on August 14th, 2019, the 2-year and 10-year yield inverted. Many economists are expecting a recession in the U.S. within the next 12-24 months.