26) The Effect of the Inverted Yield Curve
An inverted yield curve occurs when the yields on long-term bonds are lower than the yields on short-term bonds. In other words, investors demand a higher rate of return for holding shorter-term bonds than longer-term bonds. This phenomenon is significant because it is a strong predictor of an oncoming recession.
Typically, longer-term bonds offer higher yields because investors require compensation for tying up their money for a longer period. When the yield curve inverts, it implies that investors are pessimistic about the future and are willing to accept lower yields on longer-term bonds. This behavior can be a signal that investors believe the economy will slow down in the future, leading to lower interest rates, and thus, lower bond yields.
The inverted yield curve has been a reliable predictor of recessions in the past. An inverted yield curve has occurred before every recession in the United States since 1950, with only one false positive in the mid-1960s. The inversion occurs because investors anticipate a decrease in interest rates, which is usually a response to slowing economic growth. All nine recessions since 1955 have been preceded by an inverted yield curve according to research from the San Francisco Fed—except in one case.
The most closely watched inversion is the yield difference between the 10-year Treasury bond and the 2-year Treasury bond. This inversion has preceded each of the last seven recessions, including the Great Recession of 2008. However, other yield curve inversions, such as the 3-month to 10-year or the 1-year to 5-year, have also been reliable predictors of recessions.
The inverted yield curve’s reliability as a predictor of recessions can be attributed to its relationship with the credit markets. When short-term interest rates are higher than long-term rates, borrowing becomes more expensive, leading to a decrease in business investment and consumer spending. This decrease in economic activity can lead to a recession.
The Federal Reserve, the central bank of the United States, is responsible for setting short-term interest rates. In response to an inverted yield curve, the Federal Reserve may lower short-term interest rates to try to stimulate economic growth. However, if the inversion persists, it can be challenging for the Federal Reserve to avoid a recession.