What is an inverted yield curve?
In one line: An inverted yield curve is when short-term government bonds pay higher yields than long-term ones, the opposite of normal.
Normal vs inverted
Usually, lending money for longer pays more. A 10-year bond pays more than a 2-year bond, because your money is tied up longer. Plot yields from short to long and the line slopes up. That's a normal Yield curve.
When short-term yields climb above long-term ones, the line slopes down. That's an inverted yield curve.
A simple example
| Bond | Yield |
|---|---|
| 3-month bill | 5.4% |
| 2-year note | 4.9% |
| 10-year note | 4.2% |
The 2-year pays 0.7 percentage points (70 Basis points) more than the 10-year. People say the "2s10s" spread is −70 bps. The curve is inverted.
This usually happens when the Fed has raised short-term rates high to fight Inflation, while investors expect rates to fall later because growth will slow.
Why it matters
An inverted curve has come before most US recessions in the past 50 years. That's why it's called a warning light.
But the timing is loose. A Recession has often started many months to a couple of years after the inversion, if at all. The 2-year/10-year curve inverted in mid-2022 and stayed inverted for about two years. No recession was declared in that stretch.
A common mistake
Using it as a trade timer. "The curve inverted, so stocks will crash" isn't a plan. Stocks have risen for long periods while the curve was inverted. It tells you something about the economy's risks. It doesn't tell you when, or what price will do next week.
Treat it as background, like the weather report. Your entries, stops and size still come from the chart. See risk management for beginners.
Questions
Does an inverted yield curve always mean a recession?
No. It has come before most recent US recessions, but the gap in time varies a lot, and it has given false alarms.
Which yield curve do people watch?
The most quoted are the 10-year minus 2-year Treasury yields and the 10-year minus 3-month yields.
What does it mean when the curve un-inverts?
Short-term yields fall back below long-term ones. Some of the recessions in the past started around that time, so people keep watching after it happens.
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