What does the term “inverted yield curve” mean?

In the last few months many financial gurus, newspapers, financial articles, and TV personalities have been discussing the so called “inverted yield curve.” What does that have to do with us in Missouri?

Let’s described what the terms used mean and then put them together to understand better what the term inverted yield curve means. There is more than one definition being used which adds to the confusion, but the basics are the same.

For starters, yield is the interest rate paid by a borrower to a lender for the use of money provided by the lender. You pay a mortgage, it has a rate. You buy a vehicle using a loan, you pay interest. Simply put, interest rate paid on the debt is called yield in the context of investments.

The yield paid varies on many factors, but to simplify we are only going to talk about the yields earned by investors in US Treasuries. US Treasuries are issued by our Federal government and can be for various terms or maturities. A few of the more common lending periods are 30-yr, 10-yr and 2-yr.

Typically in a thriving economy the longer the investment period, the time the money is on loan to the government, the higher the rate (yield) paid on the investment.

If you were to graph this with yield on the vertical y-axis and time on the horizontal x-axis, it would be a line (or curve) going from the lower left to the upper right. By analogy, think of it as looking from the side of the runway at an airport as a plane takes-off from your left to your right – it starts on the ground and angles upward into the sky. This trajectory is a common indicator of a healthy economy.

So, what is an inverted yield curve? Essentially the shape of the curve is reversed, upside down, or inverted to the normal shape just described. For instance, the line on the graph would be from the upper left to the lower right. Back to our airplane analogy, the plane, traveling left to right, is descending to the ground.

This shape of the yield curve is termed an inverted yield curve and is a harbinger of a potential slowing economy sometime in the future. It is not a guarantee or cause and effect relationship, but rather a clue that with respect to yields (interest rates), they are not normal and the economy may decelerate in the future. That future could be two years away and many events may occur between now and then to reverse the shape of the curve and thereby suggest the economy only hinted at a slow-down, but is not really headed to a slow-down.

Just so you know, the “experts” most commonly compare the 2-yr yield to the 10-yr yield because it has more times than not been a better early warning indicator than comparison other yields combination. When the 2-yr yield is higher than the 10-yr yield, the curve is considered an inverted yield curve.

Now you know what is meant by an inverted yield curve.

Contact Steven Erickson at steve@ericksonfinancialsolutions.com if you have questions on this or other financial questions.