A yield curve is a representative graph that plots the interest rates of bonds across a series of short-term to long-term investment maturity dates. There are three types of yield curves, standard, flat, and inverted. In a standard yield curve, the graph line follows a predictable up-sloping pattern in that increased risk longer-term securities provide a higher premium to investors. A flat yield curve means that interest rates between short and long-term bond investments are the same, creating a straight line between the two metrics. An inverted yield curve occurs when the interest rate on a long-term security is lower than that of a short-term one. This market action was discovered by former New York Federal Reserve economist Arturro Estrella .
In each instance, the graph plots information on interest rates from a series of U.S. Treasury Bond maturation dates over time. Every iteration is represented. Interest rates on these bonds, seen as a traditionally safe investment, tend to follow predictable up-sloping patterns in that increased risk longer-term bonds provide a higher premium to investors. Typically the payoff is higher when investors prolong their investment period; however, in an inverted yield curve, the opposite occurs. Short-term interest rates are raised to counteract market insecurities, becoming the more attractive investment option.
The idea is that investors are seemingly losing confidence in the long-range viability of the market and anticipating that interest rates will fall. By investing in longer-term bonds, they are locking in the current rates before they begin to drop. With more money out of circulation, less is available for immediate use. This lack of flowing money negatively impacts the country’s Gross Domestic Product (GDP) . The Fed, hoping to entice investors back toward short-term offerings, will then raise its interest rates. As the rate between short-term and long-term securities evens out the yield curve flattens. When the short-term interest rate becomes higher than the long-term, it creates an inverted yield curve.
The Fed alone influences short-term bonds and raises short-term interest rates. They try to rein in borrowing and limit inflation by controlling the number of people borrowing money in a booming economy. On the opposite end of the graph, investor sentiment controls long-term security interest rates. When the economy is in solid shape, investors forego long-term bonds and invest in short term ones. When the demand for long-term bonds lessens, the price drops, pushing up the yield. The opposite occurs when investors feel that the economy will hit a rough patch. They invest in longer-term securities instead of short-term, causing the long-term yield to drop as the bond value rises.
By increasing the value of short-term securities, the Fed is hoping to increase the flow of money in circulation. However, rising short-term interest rates can also have negative ramifications. Banks determine interest rates based on these bonds, and higher rates compel them to tighten their credit-worthiness standards for marginal buyers. Consumer lending then starts to slow down. Higher interest rates also make homes less affordable, negatively affecting the housing market. The lack of available money creates concern and fear for investors; who then abandon stocks and other risky assets for the safety of treasury bills.
While it is a rare occurrence, many economists and economic pundits consider an inverted yield curve to be an indicator of a looming recession. Historically, once the yield curve inverts, the economy can take twelve to twenty-four months to be impacted . The yield curve inverted roughly fourteen months before each of the past nine U.S. recessions.  While it’s not a definitive indicator, every recession since 1956 has been proceeded by one . However, this isn’t always the case. In the United States, the last seven times that curve inversion occurred, it was a harbinger for an adverse economic event in the country.
Economists and economic pundits that doubt the correlation between the inverted yield curve and recession argue that globalization has changed the certainty that an inverted yield curve guarantees a poor outcome. Other market factors should also be considered, such as the job market, and local economic conditions as well as the economy in other parts of the world, Furthermore, the length of time that inversion occurs is also a factor, with short term blips considered to be inconsequential. In their opinion, no one factor can dictate an uptick or downturn in the economy on its own. Although there isn’t a consensus, the prevailing view among all involved parties is that an inverted yield curve is a cause for caution.
David Wessel, a Brookings Institution fellow in Washington, D.C., believes that the market runs on investor psychology rather than strictly fundamentals . Investor over-reactions could cause the very issues that they’d hoped to avoid. There are steps that smart investors can take to try and lessen the personal financial impact of any potential negative economic happenings. Don’t pull back from investing and spending, doing so takes money out of circulation and only exacerbates any issues. Instead, continue to invest conservatively, and diversify your portfolio to ensure that you are protected if any one part of the market is more heavily impacted. These actions will help to mitigate risk.
The stock market is cyclical and has been since its inception. If the yield curve has shown anything, its that upticks, stagnation, and downturns are standard parts of the financial industry. History is a series of impermanent standard, flat, and inverted yield curves, and every turn one direction leads to an eventual turn in the other. While an inverted yield curve implies some market volatility, it shouldn’t scare away investors. The certainty of the past has given way to globalization, and negative economic probabilities are no longer a sure thing. Many economists believe that investors should no longer consider an inverted yield curve a signal to exit the market. Instead, it should be treated as a “yellow light”  and incite cautious investing behaviors instead of leading to outright fear.
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