Recession Watch: Everything You Wanted to Know About the “Inverted Yield Curve” but Were Afraid to Ask
These days, it’s getting harder and harder to read, watch, or hear financial news without coming across the term “inverted yield curve”. What’s more, the folks who mention this term are never happy or excited. On the contrary, they’re grave and solemn. Some of them almost look like they’re on the verge of tears.
Now, you already know what the words inverted, yield and curve mean. But you may not know what happens when these words are put together, and what it likely means for you in terms of your job, your retirement savings, and how much it will cost to buy a house, a car, an office renovation from Key Interiors, a vacation to the Windy City, a man cave complete with plasma TV and wet bar — or anything on your purchase list or dream board.
Well, fear not: you don’t have to get an MBA, or watch endless hours of financial and business news. Instead, you can get the basics right now, right here.
It all starts with the U.S. Treasury bond market, which is widely considered to be one of the safest places to park money in times of economic uncertainty (or outright doom and gloom). Under normal circumstances, the interest rate pegged to short-term bonds is lower than long-term bonds. This makes sense, because folks who are willing to live without their money for several years should be entitled to a higher premium, compared to folks who are only willing to live without their money for a couple of years. On the flipside, folks who want to borrow money for longer should be expected to pay more vs. folks who want to borrow money for a shorter duration.
The way that this normal, logical story is depicted is through (yes, you guessed it!) a yield curve. Time is on the Y-axis. The interest rate is on the X-axis. Naturally, the curve rises over time — because as noted above, the longer the duration, the higher the interest rate.
When investors start to worry that a recession is on the horizon, they start pulling out of relatively risky assets like stocks, and they use that money to buy relatively safe assets like long-term U.S. Treasury bonds. However, eventually this activity causes the rate for long-term bonds to dip lower than for short-term bonds, which causes the yield curve to invert (hence the term). Basically, investors are so freaked out about what’s going to happen in the economy, that they’re willing to accept a lower return if it means they can park their cash and ride out the storm.
Now, does an inverted yield curve — which recently occurred, and is the reason why you keep hearing and reading about it these days — absolutely mean that a recession is going to happen? Not necessarily. There are many factors that will determine the economic ecosystem; especially what transpires on the trade war front between Washington D.C. and Beijing.
However, keep this grizzly statistic in mind: an inverted yield curve has preceded every single U.S. recession since 1950. Time will tell whether that dubious streak stays alive, or if 2019/2020 is the outlier.