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What is the Inverted Yield Curve and why it matters

Writer # Indiabonds | April 17, 2023

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In the world of bond investing, the term “yield” is synonymous with “return.” So, when referring to the “yield” of a 10-year G-Sec, what is being communicated is the 10-year “return” on that particular bond.
The yield curve is a graph that shows the relationship between the yields and the maturity dates of a series of bonds. In other words, it shows how much investors can expect to earn in interest from bonds that mature at different times.

For example, let’s say you are considering two bonds: one that matures in 1 year and another that matures in 10 years. The yield on the 1-year bond is 2%, and the yield on the 10-year bond is 6%. If you plot these yields on a graph, with the maturity on the x-axis and the yields on the y-axis, you would see a curve that slopes upward from left to right. This upward-sloping curve is called a normal yield curve, and it indicates that investors expect to earn a higher return on a longer-term bond.

Normal Yield Curve

In other words, as the borrowing tenure increases, the interest rate that must be paid also increases. The reason behind this is the substantial uncertainty that comes with long-term borrowing. It is impossible to forecast what unforeseen events may occur in the next decade or two, such as the possibility of a financial crisis leading to a global economic collapse. To compensate for this uncertainty, borrowers may need to offer a higher coupon rate to attract investors who are willing to take on the risk.

What is an inverted yield curve?

When short-term interest rates exceed long-term ones, the yield curve undergoes inversion, signaling a shift of investor funds from short-term bonds to long-term ones. Investors may anticipate lower interest rates in the future due to their belief that a recession is likely in the short term. As a result, they are willing to accept lower yields on longer-term bonds now in anticipation of lower interest rates in the future. This increased demand for longer-term bonds drives down their yields and causes the yield curve to invert.

Implications of the inverted yield curve

When short-term interest rates become higher than long-term interest rates, it leads to an economic phenomenon known as a yield curve inversion. This makes it more expensive for businesses and individuals to borrow money for investment and expansion purposes. The higher borrowing costs may discourage businesses from making new investments and consumers from making major purchases, which can slow down economic growth. Furthermore, banks may also become reluctant to lend money, as they may be concerned about the economic outlook and the ability of borrowers to repay their loans. This can reduce the availability of credit, which can further slowdown economic activity. The combination of reduced investment, consumption, and credit availability can lead to a contraction in economic activity and ultimately result in a recession.

Therefore, an inverted yield curve is considered to be a reliable predictor of economic recession, as it indicates a lack of confidence in the economy’s prospects.

A historical event is taking place in the US as the spread between short-term and long-term bond yields has reached its highest level since 1981. This occurrence is significant since over the past fifty years, an inverted yield curve has frequently been a precursor to an impending recession.

To conclude, questions on the reliability of the inverted curve yield while predicting a recession remains. The yield curve would help you assess the economy’s overall health. It will also let you know if the economy is heading for a recession. Through this, you can make better decisions as an investor. The companies can also plan the financials accordingly. An inverted yield curve can help investors, consumers, and businesses eliminate losses.


Q. What can an investor gather from an inverted yield curve?

 A. An inverted yield curve is considered a warning sign of an economic slowdown or recession, as it suggests that investors have a pessimistic outlook on the economy’s prospects.

Q. Who originally coined the term “inverted yield curve”?

A. The phrase “inverted yield curve” was first introduced by Campbell Harvey, a Canadian economist, in his doctoral thesis at Duke University in 1986.

Q. What is the accuracy of an inverted yield curve?

A. The inverted yield curve is the most reliable indicator of a declining economic downturn. However, it can be imprecise in forecasting the recession. Sometimes, the recession might come years after an inverted yield curve. It has also been observed that a recession happens every five years.

Disclaimer: Investments in debt securities are subject to risks. Read all the offer related documents carefully.