How an Inverted Yield Curve Predicts a Recession

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An inverted yield curve means that yields on short-term bonds are higher than long-term ones. A recession is imminent!. Photo: GSO Images/Getty Images

Definition: An inverted yield curve is when the yields on bonds with a shorter duration are higher than the yields on bonds that have a longer duration. It typically only happens with Treasury note yields. That's when yields on one-month, six-month or one-year Treasury bills are higher than yields on 10-year or 30-year Treasury bonds.

Why are inverted yield curves so unusual? In a normal yield curve, the short-term bills yield less than the long-term bonds.

That's because investors expect a lower return when their money is tied up for a shorter period. They require a higher yield to give them more return on a long-term investment.

What Does an Inverted Yield Curve Mean?

An inverted yield curve means that investors have little confidence in the economy. They would prefer to buy a 10-year Treasury note and tie up their money for ten years even though they receive a lower yield. That makes no logical sense. Investors typically expect a higher return for a long-term investment.

An inverted yield curve means investors believe they will make more by holding onto the longer-term bond than if they bought a short-term Treasury bill. That's because they'd just have to turn around and reinvest that money in another bill. If they believe a recession is coming, they expect the value of the short-term bills to plummet sometime in the next year. That's because the Federal Reserve usually lowers the fed funds rate when economic growth slows.

Short-term Treasury bill yields track the fed funds rate.

So why does the yield curve invert? As investors flock to long-term Treasury bonds, the yield on those bonds lower. That's because they are in demand, so they don't need as high a yield to attract investors. The demand for short-term Treasury bills falls, so they need to pay a higher yield to attract investors.

Eventually, the yield on short-term bills rises higher than the yield on long-term bonds, and the yield curve inverts.

During normal growth, the yield on a 30-year bond will be three points higher than a three-month bill. However, if investors believe that the economy will be slowing over the next couple of years, and then speeding up again in 10-20 years, they would prefer to tie up their money until then, rather than have to reinvest it sooner at much lower rates.

When Did the Inverted Yield Curve Forecast a Recession?

The Treasury yield curve inverted before the recessions of 2000, 1991, and 1981. The yield curve also predicted the 2008 financial crisis two years earlier.

It first occurred on December 22, 2005. The Fed, worried about an asset bubble in the housing market, had been raising the fed funds rate since June 2004. By December, it was 4.25 percent,  and it pushed the yield on the two-year Treasury bill to 4.40 percent. The yield on the seven-year Treasury note didn't rise as fast, hitting only 4.39 percent. 

By December 30, the discrepancy was worse. The two-year Treasury bill returned 4.41 percent, the seven-year note yield fell to 4.36 percent, and the 10-year Treasury note yield dropped to 4.39 percent.

A month later (January 31, 2006), the two-year bill yield rose to 4.54 percent. That was more than the 10-year yield of 4.49 percent.  Nevertheless, the Fed kept raising rates, hitting 5.75 percent in June 2006. 

On July 17, 2006, the yield curve inverted when the 10-year note yielded 5.06 percent, less than the three-month bill at 5.11 percent.  Investors thought the Fed was headed in the wrong direction. For more, see Subprime Mortgage Crisis: Effect and Timeline.

Unfortunately, economists ignored the warning. They thought that as long as long-term yields were low it would provide enough liquidity in the economy to prevent a recession. They were wrong.

The yield curve stayed inverted until June 2007. Throughout the summer, it flip-flopped back and forth, between an inverted and flat yield curve.

By September 2007, the Fed finally became concerned. It lowered the fed funds rate to 4.75 percent. It was a 1/2 point, which was a significant drop. The Fed meant to send an aggressive signal to the markets. The Fed continued to lower the rate ten times until it reached zero by the end of 2008. The yield curve was no longer inverted, but it was too late. The economy had entered the worst recession since the Great Depression. For more on the exact timing of the cuts, see Current Fed Funds Rate. Word to the wise -- never ignore an inverted yield curve.

Check out an interactive tool that shows the yield curve in a graphic form through the years on Smart Money