You are forgiven if you don’t know why an inverted yield curve is a big deal. Here’s what the fuss is about.
What’s a yield curve?
It’s a way to show that buyers of bonds are getting more interest for choosing to buy shorter- versus longer-term debt. Most of the time, they
demand more for locking away their money for longer periods, with the greater uncertainty that brings. So, on a graph the yield curves usually slope upward, from shorter bods yielding lower rates to higher one.
What are flat and inverted yield curves?
A yield
curve goes flat when the premium, or spread, for longer-term bonds drops to
zero — when, for example, the rate on 30-year bonds is no different than the
rate on two-year notes. If the spread turns negative, the rate curve is
considered “inverted”, sloping down from short to long term bonds.
Does it matter?
Normally sloped yield curves has usually reflected the market’s sense of the economy, particularly about inflation. Investors who think inflation will increase typically demand higher yields to offset its effect. Because inflation usually comes from strong economic growth, a sharply upward-sloping yield curve generally means that investors have rosy expectations. An inverted yield curve, by contrast, has been a reliable indicator of impending economic slumps, like the one that started in 2007. In particular, the spread between three-month bills and 10-year Treasuries has inverted before each of the past seven U.S. recessions.
What’s been happening?
Since late in 2018, markets have been concerned about the possibility of a global economic slowdown, fed in part by the trade war between the U.S. and China. Those signs of weakness led the U.S. Federal Reserve first to pause the series of interest rate hikes it had been pursuing and then to cut rates in July. At the same time, however, the Fed signaled that the cut wasn’t necessarily the start of a cycle of rate reductions. That statement kept yields on shorter-term debt anchored, while concern over the economy sent investors scrambling for the safety of long-dated Treasuries. That dropped U.S. 10-year yields below those of two-year Treasuries, while 30-year yields fell to a record low.