Most investors across the world are aware of the fact that yield curves are generally upward sloping. This is because, under normal circumstances, yields for bonds with longer maturities tend to be higher. However, it is possible for the opposite scenario to play out. This means that it is possible for bonds with lower maturities to command higher yields than bonds with higher maturity. This is an abnormal situation that occurs only a few times in several years. This phenomenon is called an inverted yield curve and it is considered to be very important from an investor’s point of view.

The details about the inverted yield curve have also been explained in this article.

Causes of Inverted Yield Curve

Since an inverted yield curve is an abnormal situation, it is important to understand why it arises.

• Interest Rate Changes: Inverted yield curves have been commonly associated with frequent short-term interest rate cuts. This is because if the rates are cut consistently, then there is a chance that inflation may increase a lot in the short run. In the long run, inflation will stabilize. Hence, the market does not demand a higher yield in the long run. However, the riskiness of investments increases significantly in the short run and this causes an inverted yield curve.

• Poor Economic Performance: A lot of times, inverted yield curves are triggered by data about poor economic performance. This is because when the economic performance is low and unemployment numbers are high, governments are forced to take measures such as rate cuts and other forms of fiscal stimulus. Once again, this increases the riskiness in the short run. This causes investors to demand higher yields in the short run.

Why Inverted Yield Curves Matter?

The occurrence of an inverted yield curve is considered to be a big issue. As soon as this yield curve is spotted, it becomes part of the news. The reason behind the importance given to the yield curve is listed below:

• Predictor of Recession: For the past five decades or so, inverted yield curves have been considered to be an important predictor of recessions. Almost every sighting of the inverted yield curve has ultimately led to a recession. This is the reason that as soon as inverted yield curves are sighted, investors and analysts begin to predict a recession and prepare for it.

• Reduces Liquidity in the Market: The inverted yield curve is considered to be correlated to recessions since it is an important predictor of liquidity in the overall market. Inverted yield curves mean that banks will have to borrow short term at high-interest rates and lend long term at relatively lower interest rates. Obviously, this is not an attractive proposition for any bank. This is the reason they tend to drastically reduce lending during this period. The sudden drop in the amount of credit in the market often leads to lower productivity since loans are difficult to come by for industries as well as individuals. This, in turn, causes a recession in the marketplace.

Effects of Inverted Yield Curve

The effects of the inverted yield curve are so significant, that their impact does not remain restricted to the bond market. Some of the details have been listed below:

• Profit Margins for Banks Decline: As mentioned above, banks borrow short term and lend long term. Hence, if the yields for the short term fall rise but the ones for the long term remain low, then their lending operation will not be very profitable. This causes banks to stop lending during inverted yield curve periods.

• Stock Markets Face a Downward Trend: Inverted yield curves have been considered to be a precursor for recessions. Stock markets generally face a massive drop in valuation during recessions. Hence, as soon as an inverted yield curve is sighted, the valuation of stocks starts seeing a downward trend. This is the reason that inverted yield curves make headlines across the world since they often precede stock market corrections.

• Lower Bond Spread in the Short Run: In a normal market, there is a significant spread between the bonds issued by governments and the ones issued by private corporations. When an inverted yield curve is sighted, this situation changes. The short-term rates at which people are willing to lend to the government or to private bodies begin to merge. This is because the riskiness of both is considered to be somewhat similar in such situations.

• Essential Commodities Witness an Upward Trend: Lastly, it is common for essential commodities to witness an upward trend during periods of inverted yield curves. This is because commodities such as gold, silver, etc. are considered to be a safe bet against inflation and recession. Fears of inflation and recession cause people to redirect their money from stocks and other investments to essential commodities. This is why essential commodities witness a bull run which can be correlated with an inverted yield curve.

To sum it up, an inverted yield curve is considered to be a major economic event. Almost all financial markets in the world are impacted by inverted yield curves in the long run.