A yield curve is a line that plots bond interest rates (also called yields). Specifically, it plots yields on bonds with the same credit quality that mature at different times, such as Treasury bonds.
For example, a 2-year Treasury bond yielding 2%, a 10-year Treasury bond yielding 5%, and a 30-year Treasury bond yielding 6% plotted on a graph with yields on the Y axis and maturities on the X axis forms a line that slopes upward, representing a normal yield curve. This illustrates the typical relationship between bond length and bond yield: the longer the bond term, the more it pays.
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What is an Inverted Yield Curve?
An inverted yield curve is just the opposite. It happens when short-term bonds are paying higher yields than long-term bonds. On a graph, the line slopes downward.
Part of the reason for the current yield curve inversion is related to the Federal Reserve’s decision to raise interest rates from near zero at the start of 2022 to a target range of 3% to 3.25% in September. The series of interest rate hikes is meant to tame inflation. If interest rates continue going up as predicted, long-term bond prices will likely fall further, making short-term bonds — which are typically less sensitive to interest rate changes — more attractive to investors.
What Does an Inverted Yield Curve Tell Investors?
An inverted Treasury yield curve usually signals a coming recession. According to the Federal Reserve Bank of New York, every US recession since 1950 was preceded by an inverted yield curve. It essentially means that investors have little faith in future economic growth.
The missing piece is timing — an inverted yield curve doesn’t predict when a recession will happen. In past instances when an inverted yield curve led to a recession, the time between the two events was anywhere from a couple of months to a few years.
The 10-Year Treasury Yield
The 10-year Treasury yield climbed to 3.57% on September 20, marking an 11-year high, according to the Federal Reserve Bank of St. Louis (FRED).
Why Is the 10-Year to 2-Year Spread Important?
The difference between 2-year and 10-year Treasury yields is known as a spread. It’s important because those maturities are benchmarks for short-term and long-term bonds, respectively.
A negative spread between the two Treasurys means short-term bonds have higher yields than long-term bonds of the same credit quality. Ahead of the Fed’s latest rate hike on September 21, the spread measured -0.51%, according to FRED, compared to 1.11% a year prior.
The New York Fed uses a slightly different spread to gauge the probability of a recession, measuring the yields of the 10-year Treasury bond and the 3-month Treasury bill. As of August 2022, it calculated that there was a 25.15% chance of a recession occurring in the following 12 months.
The inverted yield curve tends to command a lot of airtime. Take care not to overemphasize its predictive power. A recession is not necessarily imminent, but it still may be a good time for an investment check in.
Author is not a client of Personal Capital Advisors Corporation and is compensated as a freelance writer.
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