What Does the Inverted Yield Curve Mean?

If you follow the news, you may be wondering what the heck an inverted yield curve is or why it spooks the stock market.

Like many financial terms, “inverted yield curve” sounds more complicated than it really is. And learning the basics of the concept will help put you at ease when you’re bombarded by doomsday headlines like those that have dominated national news since Wednesday morning.

So, let’s break it down.

What is an inverted yield curve?

Typically, long-term bonds pay more than short-term bonds. This makes sense: If you agree to tie up your money for longer periods of time, you should be paid more for your trouble. This is why a five-year certificate of deposit pays more than a one-year CD.

Rarely, however, the reverse occurs: Longer-term bonds start paying less than short-term bonds. When that happens, a recession often follows. In fact, this situation, known as an inverted or negative yield curve, has proven a highly accurate recession predictor.

Why would long-term bonds ever pay less than short-term bonds? Well, the Federal Reserve controls short-term rates, but the market controls the rates on longer-term securities.

The Fed can raise short-term rates, which is exactly what they did from December 2015 through December 2018. The Fed did drop rates last month, though it was the first time they had done so since 2008, after which the Fed entered a period of several years with no action on rates.

If investors start thinking things don’t look so good in the economy, however, they keep their powder dry by buying long-term bonds. The more they buy and bid up the price of long-term bonds, the lower the rates on these securities go, increasing the likelihood of an inverted yield curve.

What just happened to the yield curve?

On Wednesday, a Treasury market yield curve inverted, with the yield on 10-year Treasury notes (1.623%) falling below that of two-year Treasurys (1.634%).

It was the first time since 2007 that this curve inverted — and the stock market panicked over the recession indicator. The Dow Jones Industrial Average, the S&P 500 and the Nasdaq each dropped by 2.6% to 2.9%.

Investors also sought out federal government bonds, considered among the safest investments out there. As a result, the yield on 30-year Treasurys fell below 2% for the first time ever on Thursday morning.

Did the stock market or investors overreact?

Well, former Federal Reserve Chairwoman Janet Yellen did caution that Wednesday’s yield curve inversion may not be as reliable of a recession indicator. She said Wednesday on Fox Business:

“Historically, it has been a pretty good signal of recession, and I think that’s when markets pay attention to it, but I would really urge that on this occasion it may be a less good signal. And the reason for that is that there are a number of factors other than market expectations about the future path of interest rates that are pushing down long-term yields.”

Remember, panicking along with the market or the masses is a cardinal investing sin.

As “9 Tips for Sane and Successful Stock Investing” explains:

“One common rookie investor mistake is reacting emotionally to stock market ups and downs. If you pulled out of stocks after the 2008 crash, for example, you may have missed the gains from the bull market that followed. Remember: You are in this for the long haul.”

What’s your take on this news? Sound off by commenting below or over on the Money Talks News Facebook page.

Stacy Johnson and Karla Bowsher contributed to this post.