Inverted Yield Curve

An inverted yield curve is a yield curve in which short-term interest rates are higher than long-term interest rates on debt of the same issuer and credit quality, usually government bonds. Normally lenders demand more to lock up money for longer, so the curve slopes upward. When it slopes downward instead, at least over part of its length, the curve is said to be inverted. In the United States, an inversion of the Treasury curve has preceded most recessions of the past half-century, which is why it is closely watched, but the lag is long and variable and the signal has not been infallible.

Inversion is usually described in terms of a spread between two maturities. The most cited measures are the difference between the 10-year and 2-year Treasury yields and between the 10-year yield and the 3-month Treasury bill rate. A negative spread means the curve is inverted between those points.

Short-term yields are anchored by the policy rate set by the central bank, such as the federal funds rate in the United States. Long-term yields reflect the market's expectation of average short-term rates over the life of the bond plus a term premium for bearing duration risk. An inversion typically appears when the central bank raises short rates sharply to fight inflation, while investors expect that tighter policy will slow the economy and force rates down later. Long-term yields then stay below short-term yields.

A low or negative term premium can also flatten or invert the curve. Strong demand for long-dated Treasury bonds from pension funds, insurers, foreign central banks and, in some periods, central bank purchases under quantitative easing can push long yields down without any change in growth expectations.

Academic work in the 1980s, including research by economist Campbell Harvey, documented the predictive power of the US curve's slope for economic growth. Since the late 1960s, inversions of the 10-year to 3-month spread have come before every US recession, typically by somewhere between six months and two years. The Federal Reserve Bank of New York publishes a model that converts the spread into a probability of recession a year ahead.

The signal has weaknesses. The lead time is too irregular for precise timing, and the curve has inverted without a recession following within the usual window. The 10-year to 2-year spread inverted in July 2022, as the Federal Reserve raised rates rapidly, and stayed inverted until around September 2024, the longest such episode on record. A US recession had not followed by the time the curve returned to a positive slope, leading many analysts to argue that low term premiums and post-pandemic distortions had weakened the indicator.

Commercial banks traditionally borrow short through deposits and lend long, the practice known as maturity transformation. An inverted curve squeezes the difference between what they pay and what they earn, putting pressure on their net interest margin. Banks may respond by tightening credit standards, which can itself help slow the economy. The rapid rise in short rates in 2022 and 2023 also produced large unrealized losses on long-dated bonds held by banks, a factor in the failure of several US regional banks in March 2023.

For money market investors, an inverted curve means cash and short-dated instruments pay more than long bonds, which tends to draw funds into money market funds and short Treasury bills.

Suppose the 2-year Treasury yields 4.90 percent and the 10-year yields 4.20 percent. The 10-year to 2-year spread is minus 0.70 percentage points, or minus 70 basis points, so the curve is inverted over that segment. If the central bank later cuts its policy rate and the 2-year yield falls to 4.00 percent while the 10-year stays at 4.20 percent, the spread turns positive at 20 basis points. A return to a positive slope after an inversion is sometimes called un-inversion or steepening, and some analysts regard that phase, rather than the initial inversion, as the nearer warning.

A flat curve shows similar yields across maturities and often appears on the way to or from inversion. A humped curve has medium-term yields above both short and long yields. Central banks can influence the shape directly: yield curve control, used by the Bank of Japan from 2016, targets a specific long-term yield. Changes in monetary policy expectations and in the supply of government debt remain the main drivers of the curve's slope in most markets.