An inverted yield curve occurs when short-term investments pay higher interest rates than long-term investments, indicating a lack of confidence in the long-term economic climate. It may predict a recession, as seen in 2006 before the 2007 recession. However, other factors should also be considered. A flat yield curve often precedes an inverted yield curve.
Traditionally, long-term investments pay higher interest rates than short-term investments. If investors lose confidence in the long-term economic climate, there may be greater demand for short-term investments. This demand could lead to short-term investments that pay higher interest rates or returns than long-term investments. In this situation, there is an inverted yield curve. Some investors and economists believe that an inverted yield curve is a predictor of recession.
Specifically, the yield curve is the difference between the short-term and long-term investment returns of United States Treasury securities. Most financial experts agree that the difference between the 3-month Treasury and the 10-year Treasury yield is a good indicator of the current yield curve. Generally, the longer the investment term, the greater the risk. A higher interest rate is paid to offset this risk. If a 3-month security paid a higher interest rate than a 10-year security, an inverted yield curve would exist.
An inverted yield curve has sometimes led to recession in the United States. For example, the yield curve inverted in August 2006 and a recession began in December 2007. It is also important to consider the other underlying factors that led to this recession. During this time, home values and the corresponding mortgage-backed security securities inflated enormously.
The financial stability of the banks and other financial institutions that were heavily invested in these securities collapsed. The instability reached other companies and unemployment rose significantly. A general lack of confidence in the economy followed and triggered a recession. In this case, the inverted yield curve preceded the recession.
When consumers and institutional investors begin to see short-term investment returns equal to long-term investment returns, this represents a flat yield curve. A flat yield curve is generally a sign that an inverted yield curve will follow. As soon as short-term investment returns exceed long-term investment returns, the yield curve inverts. For example, when a 6-month certificate of deposit (CD) at a local bank or credit union pays a higher interest rate than a 12-month CD, the yield curve is inverted.
Inverted yield curves may indicate a general lack of confidence in long-term economic health. For an inverted yield curve to exist, there is usually a high demand for short-term investments. An inverted yield curve sometimes preceded a recession, but not always. Although the 2006 inverted yield curve was followed by a late-2007 recession, an inverted yield curve in 1966 and a flattened yield curve in 1998 did not lead to recessions.
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