Inverted Yield Curve
Tue, Apr 15An inverted yield curve occurs when the yields on short-term bonds surpass those on long-term bonds. This situation often signals a potential recession or economic decline. Because yield curve inversions are uncommon, they attract considerable attention in financial markets when they happen.
The yield curve visually illustrates the relationship between the interest rates of assets, usually government bonds, and their time to maturity. It is also known as the term structure of interest rates, with interest rates displayed on the vertical axis and time to maturity on the horizontal axis.
Typically, there is a positive correlation between interest rates and time to maturity, resulting in a positively sloped yield curve. However, if this correlation becomes negative, the yield curve will show a negative slope, indicating an inversion. Historically, such inversions have been precursors to recessions and economic slowdowns.
To evaluate an inverted yield curve, analysts often examine the spread between 10-year and 2-year bonds. If this spread falls below zero, it indicates a negative slope in the yield curve over a timeframe of 24 to 120 months.
The yield curve acts as a gauge of the bond market's confidence in the economy. Expectations about future interest rates shape its form. A positively sloped curve reflects optimism regarding economic performance, while a negatively sloped curve suggests pessimism. An inverted yield curve implies that investors foresee lower future interest rates, which generally leads to diminished investment returns and is linked to economic stagnation and deflation. In response to deflationary pressures, central banks may reduce short-term interest rates, aligning with the expectations of an economic slowdown indicated by a negatively sloped yield curve.
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