Traditionally, long-term investments pay higher interest rates than short-term investments. If investors lose confidence in the long-term economic climate, there can be a higher demand for short-term investments. This demand could lead to short-term investments paying higher interest rates, or yields, than long-term investments. In this situation, an inverted yield curve exists. Some investors and economists believe that an inverted yield curve is a predictor of recession.
Specifically, the yield curve is the difference between the short-term and long-term investment yields of United States Treasury securities. Most financial experts agree that the difference between the 3-month Treasury bill and the 10-year Treasury bond yields is a good indicator of the current yield curve. Usually, the longer the investment term, the higher the risk. A higher interest rate is paid to compensate for this risk. If a 3-month security paid a higher interest rate than a 10-year security, an inverted yield curve would exist.
An inverted yield curve has sometimes led to recession in the United States. For example, the yield curve inverted in August 2006 and a recession started in December 2007. It is important to also note the other underlying factors that led to this recession. During this time, home values and the corresponding mortgage-backed security values were grossly inflated.
The financial stability of banks and other financial institutions that were heavily invested in these securities collapsed. Instability trickled down to other companies and unemployment rose significantly. An overall lack of confidence in the economy followed and triggered a recession. In this case the inverted yield curve preceded the recession.
When consumers and institutional investors start to see short-term investment yields equal long-term investment yields, this represents a flat yield curve. A flat yield curve is generally a sign that an inverted yield curve will follow. As soon as short-term investment yields overtake long-term investment yields, the yield curve is inverted. For instance, when a 6-month certificate of deposit (CD) at a local bank or credit union pays a higher interest rate than a 12-month CD, the yield curve is inverted.
Inverted yield curves may point to an overall lack of confidence in long-term economic health. For an inverted yield curve to exist, there is usually a high demand for short-term investments. An inverted yield curve has sometimes preceded a recession, but not always. Although the 2006 inverted yield curve was followed by a late 2007 recession, an inverted yield curve in 1966 and a flat yield curve in 1998 did not lead to recessions.