The yield curve is one of the most closely watched charts in finance, as it describes the relationship between short- and long-term interest rates. Normally, the yield curve is upward sloping, meaning that investors are paid more to lock up their money for longer periods. However, on occasion, the yield curve can flip, resulting in an inverted yield curve that can significantly impact returns for fixed income and equity investors alike.
How the Yield Curve Works
The yield curve is a graph of the interest rates, or yields, that investors can earn from buying different maturities of a particular type of debt. Normally, when people talk about the yield curve, they're referring to U.S. Treasuries, or the debt issued by the U.S. government through the Department of the Treasury. The yield curve plots the returns for three-month, six-month, one-year, two-year, five-year, 10-year and 30-year Treasuries.
The Inverted Yield Curve and Its Causes
The typical yield curve is upward sloping, and investors who buy longer-term securities earn more on their investment. Thus, a one-year Treasury note will pay more than a three-month Treasury bill. However, the yield curve can sometimes invert. One of the main reasons for inversion is the expectation that future interest rates will fall if the economy is slowing down or headed toward a recession. In addition, the yield curve can flatten or invert due to unrelated factors, such as reduced expectations for inflation, central bank policy and the investing activities of institutional investors, such as pension funds and hedge funds.
Historical Yield Curve Scenarios
Inverted yield curves have been followed by recessions within 14 months six out of seven times over the past 50 years, according to the Seeking Alpha website. With the exception of the 1966 yield curve inversion, which was triggered by government spending reductions, all other inversions have been followed by recessions. While the correlation over this period has been strong, inversion isn't a perfect predictor, as the yield curve is influenced by multiple factors.
Impact on Investment Returns
Investors facing an inverted yield curve might want to revisit their investment decisions. Fixed income investors have fewer incentives for loaning their money for long periods of time, as the returns on short-term debt exceed those of long-term debt. In addition, the spread between government debt and riskier corporate debt is minimized, making Treasuries especially attractive. Equity investors are also affected, as many sectors of the market sell off in favor of defensive stocks that will fare well in an economic recession, such as those of tobacco, energy and food companies.
Giulio Rocca's background is in investment banking and management consulting, including advising Fortune 500 companies on mergers and acquisitions and corporate strategy. He also founded GradSchoolHeaven.com, an online resource for graduate school applicants. He holds a Bachelor of Science in economics from the University of Pennsylvania, a Master of Arts in English from the University of Hawaii at Manoa, and a Master of Business Administration from Harvard University.