What an inverted yield curve means
An inverted yield curve is when short-term bonds pay more than long-term ones. Here is what that means and why it gets so much attention.
An inverted yield curve is when short-term government bonds pay higher yields than long-term ones. It is unusual, and it often appears in the news as a possible warning sign for the economy.
To understand it, you first need to know what a normal yield curve looks like.
What the yield curve is
A yield is the yearly return on a bond based on its current price. You can read more in what a bond is.
Governments borrow for many lengths of time, from a few months to 30 years. The yield curve is a chart that plots the yield on each of these bonds, from the shortest to the longest.
The normal shape
Most of the time, longer bonds pay more than shorter ones. The line on the chart slopes upward from left to right.
There are good reasons for this:
- Lending money for 10 years ties it up longer than lending for 3 months.
- More can go wrong over a long period, including higher inflation.
- Investors usually want extra return for taking on that extra time and uncertainty.
What inversion means
When the curve inverts, short-term yields rise above long-term yields. The line slopes down instead of up.
Investors are accepting less to lend for 10 years than for 2 years. That is the opposite of what you would normally expect.
Why it happens
Two forces usually combine.
Short-term yields are pushed up by central banks. Short-term yields follow the policy rate closely. When the Federal Reserve or the Bank of Canada raises rates to fight inflation, short-term yields rise with them.
Long-term yields reflect expectations. Long-term yields depend on what investors expect over many years. If they think the economy will slow and rates will be cut later, they are willing to lock in today's long-term yield. Their buying pushes long-term bond prices up and long-term yields down.
When short yields are high and long yields are held down, the curve can invert.
Which yields people compare
There is no single official measure. The most common comparisons are:
- The 2-year vs the 10-year. Often called the "2s10s" spread.
- The 3-month vs the 10-year. Used in some economic research.
The spread is simply the difference between the two yields. When the long yield is below the short yield, the spread is negative and the curve is inverted.
You can read more about the long end in what the 10-year Treasury yield tells you.
Why it gets attention
In the US, an inverted yield curve has come before most recessions over the past several decades. That track record is why economists and reporters watch it closely.
It may also play a direct role. Banks often borrow at short-term rates and lend at long-term rates. When the curve inverts, that becomes less profitable, and some banks may lend less. Less lending can slow the economy.
Why it is not a sure signal
An inverted curve is a warning sign, not a forecast with a date attached.
- Timing varies. In past cases, the gap between inversion and a recession has ranged from months to more than a year.
- False alarms happen. The curve has inverted at times without a recession following soon after.
- Conditions change. Central bank bond buying and other forces can affect long-term yields in ways that make the signal harder to read.
It is one input among many. Others include monthly jobs data, GDP and inflation data.
The curve in Canada
Canada has its own yield curve, built from Government of Canada bonds. It often moves in a similar way to the US curve because the two economies are closely linked. But it can invert or un-invert at different times, depending on Bank of Canada decisions and Canadian conditions.
When the curve un-inverts
The curve returns to normal when short yields fall below long yields again. This often happens when central banks start cutting rates. In some past cycles, a recession began around the time the curve returned to normal, not while it was inverted. This is one more reason the signal is hard to time.
The short version
- The yield curve shows government bond yields from short to long terms.
- Normally, long-term bonds pay more than short-term ones.
- An inverted curve means short-term yields are higher than long-term yields.
- In the US, inversions have often come before recessions, but not always.
- It is a warning sign to watch, not a timing tool.
This is general information, not investment advice.
Updated