Inverted Yield Curve Meaning and Examples

First, let's review "What is a treasury?" and "What is the yield curve?". Treasuries are debt obligations by the federal government or loans to the government. Buyers of treasuries are lending to the U.S. government in exchange for interest. 

You may have heard the terms "Treasury bills," "Treasury notes" and "Treasury bonds" and assumed they are the same, but they aren't. Treasury bills, or T-bills, are short-term debt obligations maturing in one year or less. These bonds are sold at a discount and then grow into full value at maturity. 

Treasury notes range in maturity from one-year, two-year, five-year, seven-year or 10-year increments. Treasury bonds mature in either 20 years or 30 years. The interest paid on the treasuries is not exactly the same as the yield. The yield is the annualized percentage return, while the interest is the amount of money and percentage of the principal paid to an investor annually. 
Under normal circumstances, a longer-maturity treasury would pay a higher yield than a shorter-maturity treasury due to the time risk factor. This applies when you buy a certificate of deposit (CD) at a bank. You will notice that CDs with longer maturities pay a higher interest rate than those with a shorter maturity (e.g., a two-year CD versus a six-month CD). The additional interest should offset the uncertainty and risks of holding it longer. 

Event and systemic risk is always associated with investing for longer periods. The same applies to treasuries. Longer-maturity treasuries should pay a higher yield than shorter-term treasuries, like a 10-year Treasury paying a 1.356% yield versus a two-year Treasury paying a 0.238% yield on August 10, 2021. This is a normal yield curve. The spread is positive at 1.118%, which confirms the normal yield curve. With each longer maturity, the yield continues to climb.

What is inverted yield curve? What does it mean when the yield curve inverts, exactly?

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An inverted yield curve occurs when the opposite happens, where the shorter maturity has a higher yield than the longer-dated maturity. The longer the maturity, the lower the yield goes. 

The 10-year versus two-year Treasury daily chart shows an inverted yield curve on August 11, 2022. The two-year Treasury (orange) has a 3.228% yield, higher than the 10-year Treasury yield of 2.890% on the same day. The difference between the 10-year and the two-year Treasury goes negative, indicating an inversion yield curve. The spread between the 10-year and two-year Treasury is -1.872%, confirming the inversion. 

What does inverted yield curve mean? An inverted yield curve occurs when short-term bond yield is higher than long-term bonds. Long-term bonds are riskier than short-term bonds and should be paying a higher yield because of it. When an inverted yield curve forms, it can mean many things. 

The most common meaning investors assign to an inverted yield curve is that it's a warning sign of an economic recession. If investors feel a recession is on the horizon, they will jump into long-term bonds disproportionately and drive up prices, which lowers yields. Inverted yield curves have been an accurate predictor of recessions. 

They have predicted and preceded 10 recessions since 1955, with a single false positive in the mid-1960s. The time between an inversion and recession has ranged from months to over a year. Not every inversion has led to a recession, as many other factors are involved, so it's more of a warning indicator. What does it mean when a yield curve inverts? Let's find out.

The yield curve briefly inverted in August 2019, preceding a brief recession triggered by the COVID-19 pandemic, an unprecedented anomaly. The economy quickly rebounded, but the yield curve inverted in July 2022 and has remained inverted for over a year through August 2023.

Sentiment is a key drive of the yield curve. A yield curve inversion can form when investors and institutions overwhelmingly and disproportionally buy long-term treasuries, driving down yields. 

The question is, what causes the surging demand for long-term treasuries? In most cases, it's due to a risk-off stance where investors seek safety and stability and are willing to sacrifice yield. There are many instances where this can occur:

• Recession fears: Long-term bonds rise in value as yields fall when investors and institutions pour into them, anticipating an economic slowdown. The fear of recession can often be a self-full-filling prophecy. Investors taking proactive measures like buying long-term treasuries or swapping out short-term notes with long-term treasury bonds can lend toward yield curve inversion. 
• Geopolitical risk: Any geopolitical event that causes an inflow into long-term government bonds can trigger an inversion. Other nations that may feel their interest rates are too low may swap into U.S. Treasury bonds, causing the yield to fall.  
• Central bank actions: Fed monetary tightening policy actions like raising short-term interest rates can cause a yield curve inversion. The Fed can raise interest rates to combat inflation and slow the economy from overheating. A tightening monetary policy where the Fed raises short-term interest rates to combat inflation and cool down an overheated economy can also cause an inverted yield curve. The aggressive rate hikes implemented by the Fed in 2022 led to an inverted yield curve. 
• Flight to safety: Domestic and international investors may seek safety and stability due to market or geopolitical volatility. They may buy up 20-year and 30-year Treasury bonds to cause values to rise while yields fall. Bond prices and yields have an inverse relationship. A flight to quality where investors seek to take off risk and buy long-term treasuries can also lend to an inverted yield curve as buying demand causes yields to fall.

Historically, a recession has occurred from months to over a year after the yield curve inverted. It's hard, if not impossible, to predict with much certainty the exact time it will occur. Remember that a recession refers to a significant economic decline and a business cycle contraction. 

Technically, a recession is two consecutive quarters of negative gross domestic product (GDP) growth. Other factors like rising unemployment levels, contracting income and manufacturing and falling retail sales all lend to a contracting business cycle. A falling stock market or a bear market is also associated with recessions. The National Bureau of Economic Research (NBER) determines the official starting and ending dates of U.S. recessions which expects more than two months of falling GDP to declare a recession officially.