Understanding The Inverted Yield Curve

The inverted yield curve is one of the available tools investors use to track if the trajectory of the stock market is going bad.

In the finance or investment world, a yield curve is a graphical representation that plots the expected yields of fixed-interest securities like debt investments against the period of time they have before maturing.

In order words, for a 10-year period, the yield curve is a tool that investment analysts use to monitor the expected investment gains even if it is just to be used as a guide.

The inverted yield curve is one of the available tools investors use to track if the trajectory of the stock market is going bad. In order words, it tells you or at least gives you a hint as to whether the stock market is generally doing well or there is an impending crash waiting for you.

However, before we understand what the inverted yield curve is all about, we need to know what the normal yield curve looks like or is about.

The yield curve typically shows you how much you’re expected to earn in the short term and how much you’re expected to earn in the long term. In the normal yield curve, short-term debt instruments have a lower yield than long-term debt instruments that have the same variables or qualities.

The normal yield curve is known to have an upward slope as short term gains would always be lower than long term gains and can only rise over time by growing. This is also known as a positive yield curve.

In the longer term, not only are the expected gains higher, the interest rates are lower than those in shorter terms. And this is only logical because if your money is going to be tied up for a long time, you must be compensated for it.

But as you might have already guessed, in the case of the inverted yield curve, everything changes. In other words, short-term debt instruments have a higher yield than long-term debt instruments that have the same variables or qualities.

The inverted yield curve is a complete reversal of the normal yield curve and is thus an indicator that something is going wrong. When investors become willing to accept lower returns on longer-term debt securities than on shorter-term ones, it means they believe that the investment returns of the longer term would be even lower than what it currently prevails at.

It is also known that inverted yield curves have come before many of the past recessions and is in fact believed to be a way to predict darker times coming. Just like everything in the investment world, investors’ perception drives it.

As such, when longer-term bonds are widely demanded, yields are expected to go down in value.

Also, yields on longer-term securities could be going down in situations where market interest rates are set to reduce in the near future so as to accommodate certain ongoing weak economic activities.

This is why it is often said that the shape of the yield curve changes in accordance with the state of the economy. The normal yield curve shows that the economy is growing and the inverted yield curve shows that the economy is moving closer to a recession.

It is important to note that the inverted yield curve does not guarantee a recession. As such, investors should not result to panicking in cases of one. As such, investors should maintain appropriate asset allocation levels and not make unnecessarily abrupt decisions.

Written by Lawretta Egba.