Friday, July 19, 2024

Inverse Yield Curve

In this article, We learn about “Inverse Yield Curve “.Let’s Go!

An inverse yield curve is when bonds with shorter maturities have higher yields than bonds with longer maturities.

It often heralds a recession or economic slowdown.

Because yield curve inversions are rare, they usually attract attention from the financial community when they occur.

What is an inverted yield curve?

The yield curve is a graphical representation of the relationship between the interest rate an asset (usually a government bond) pays and its time to maturity.

The

yield curve is also known as the term structure of interest rates.

The vertical axis measures interest rate, and the horizontal axis measures time to maturity.

Normal vs. Inverted Yield Curve

Generally, interest rates and maturity are positively correlated.

Under normal circumstances, interest rates rise as the maturity period increases. This results in a yield curve with a positive slope .

If interest rates and time to maturity are negatively correlated, then the resulting inverse yield curve will show negative slope.

Historically, the yield curve has had a negative slope before recessions and economic slowdowns.

How to measure an inverted yield curve

The spread between the

10-year bond and the 2-year bond is often used to check if the yield curve is inverted.

If the 10-2 spread is below 0, the yield curve has a negative slope on average between 24 months and 120 months (time to maturity).

Inverted Yield Curve for Forecasting Future Recessions

The yield curve is often viewed as a gauge of the bond market’s confidence in the economy.

Expectations of future interest rates shape the yield curve.

  • A positive slope means the bond market expects the economy to perform well.
  • A negative slope means the bond market expects the economy to underperform.

A negatively sloping (“inverted”) yield curve means investors expect lower interest rates in the future.

This means that future investment returns will generally be lower.

Lower returns lead to less investment associated with economic stagnation and deflation.

Central banks often respond to deflationary pressures in the economy by lowering short-term interest rates. Therefore, expectations of an economic slowdown are consistent with a negatively sloping yield curve.

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