Question

If the U.S. yield curve inverts, what does that imply for future interest rates and for the economy?

Answer 1

The term yield curve refers to the relationship between the short- and long-term interest rates of fixed-income securities issued by the U.S. Treasury. An inverted yield curve occurs when short-term interest rates exceed long-term rates.

Interest Rates and Yield Curves

Typically, short-term interest rates are lower than long-term rates, so the yield curve slopes upwards, reflecting higher yields for longer-term investments. This is referred to as a normal yield curve. When the spread between short-term and long-term interest rates narrows, the yield curve begins to flatten. A flat yield curve is often seen during the transition from a normal yield curve to an inverted one.

When a yield curve inverts, it's because investors have little confidence in the near-term economy. They demand more yield for a short-term investment than for a long-term one. They perceive the near-term as riskier than the distant future. They would prefer to buy long-term bonds and tie up their money for years even though they receive lower yields. They would only do this if they think the economy is getting worse in the near-term.

While yield-curve inversions have successfully signaled recessions for the past 50 years, the economic downturns can come as far out as 34 months afterward

On average, markets rally about 15% after the yield-curve inversion.

While inversions tend to spark market sell-offs the day they happen, the indicator often arrives many months before the economy falls into a recession. The downturn tends to hit hardest about 22 months after a "2-10" inversion.

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