Inverted Yield Curve: What it means for investors

An inverted yield curve is often seen as a signal of a looming recession. This just happened in August 2019.

Many people are asking if this inverted yield curve means investors are headed for a recession.

In this post I’m going to breakdown very simply what an inverted yield curve is, and what it means for investors.

An Inverted Yield Curve in Plain English

We hear about the stock market every day. The S&P 500 is up 0.6%, the Dow Jones is down 400 points…it never stops. Think about the stock market as a device which tells exciting short stories about companies. When a stock price goes up, investors view the company positively. The inverse is true when a stock price goes down.

Day-to-day, nobody knows exactly why stock prices behave the way they do; it’s rarely due to just one thing.

  • The length and severity of an inversion may have an impact on the outcome
  • The recent inversion may be distorted by an influx of investors buying US bonds

Understanding the Yield Curve

Critical to understanding the yield curve is bond maturity. A bond’s maturity determines when a bond will be repaid to an investor. For example, a 10-year bond will mature in 10 years; meaning the holder will receive the bond principal at that time.

A bond yield is simply the interest payment paid by the bond divided by the price.

A yield curve plots the relationship between bonds of different maturities and their corresponding yields, commonly 10-year and 2-year treasury bonds.

inverted yield curve versus normal yield curve

Possible Causes of an Inverted Yield Curve

There can be many reasons for an inverted yield curve. Before we discuss a current theory, it’s important to understand two things: how supply and demand impacts price and how the price of a bond impacts the yield.

When treasury bonds are issued, they come with a fixed interest rate. The price of the bond after issue, however, is not fixed and is determined by the market. As demand increases, the price of a bond goes up. When the price of a bond goes up, the yield decreases.

Therefore, when the yields of long-term bonds decrease it flattens the yield curve, and if severe enough, can result in an inversion.

How supply and demand impacts yield curves
Annual Interest Payment / Price = Yield

Implications of an Inverted Yield Curve

The simple implication of an inversion is if smart investors see more risk ahead in the next two years than 10 years down the road, it’s not good for short-term growth.

A yield curve inversion is also terrible for banks. This is because banks generate a majority of their revenue from the spread of their funding cost and return on lending.

When the curve is normal, banks have an incentive to borrow short-term loans at lower rates and lend long-term loans (think mortgages) at higher rates.

When the curve is inverted, short-term lending becomes more expensive than long-term lending. This results in lower profitability, and when lending becomes less profitable for banks, they tend to pull back. This is often accomplished by tightening lending standards.

With a reduced velocity of lending, the economy can slow down.

What Does this Mean for Investors?

The historical average time between an inversion and possible recession is typically 11 months according JP Morgan Asset Management.

But it’s important to remember that an inverted curve has occurred in the past without resulting in a recession. This happened twice: once in 1965 and another in 1998. It’s possible this could just be another case of a false positive.

An inverted yield curve preceding a recession may also depend on the length and severity. In August 2019 the inversion was brief, short, and lasted less than a day.