Inverted Yield Curve

Historically, an inverted yield curve has been viewed as an indicator of a pending economic recession. When short-term interest rates exceed long-term rates, market sentiment suggests that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall.

More recently, this viewpoint has been called into question, as foreign purchases of securities issued by the U.S. Treasury have created a high and sustained level of demand for products backed by U.S. government debt. When investors are aggressively seeking debt instruments, the debtor can offer lower interest rates. When this occurs, many argue that it is the laws of supply and demand, rather than impending economic doom and gloom, that enable lenders to attract buyers without having to pay higher interest rates.

Inverted yield curves have been relatively rare, due in large part to longer-than-average periods between recessions since the early 1990s. For example, the economic expansions that began in March 1991, November 2001, and June 2009 were three of the four longest economic expansions since World War II.3 During these long periods, the question often arises as to whether an inverted yield curve can happen again.

Economic cycles, regardless of their length, have historically transitioned from growth to recession and back again. Inverted yield curves are an essential element of these cycles, preceding every recession since 1956.4 Considering the consistency of this pattern, an inverted yield will likely form again if the current expansion fades to recession.

Upward sloping yield curves are a natural extension of the higher risks associated with long maturities. In a growing economy, investors also demand higher yields at the long end of the curve to compensate for the opportunity cost of investing in bonds versus other asset classes, and to maintain an acceptable spread over inflation rates.

As the economic cycle begins to slow, perhaps due to interest rate hikes by the Federal Reserve, the upward slope of the yield curve tends to flatten as short-term rates increase and longer yields stay stable or decline slightly. In this environment, investors see long-term yields as an acceptable substitute for the potential of lower returns in equities and other asset classes, which tend to increase bond prices and reduce yields.

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