What’s the “inverted yield curve”? Recession fears explained

Stock markets fell on Wednesday with the Dow and S&P 500 indexes each down about 2.5% after news of what investors call an “inverted yield curve.”

What does that mean?It’s an economic indicator from the bond market that has predicted the last seven recessions, dating back to 1969, as Yahoo Finance reports. The yield curve refers to the range of yields, or effective interest rates, on government bonds issued by the U.S. Treasury.

In most situations, longer-term bonds pay out a higher yield than shorter-term ones. That’s because investors want more compensation for locking up their money for a longer period of time, similar to how you can often get a better rate from your bank by putting money into a certificate of deposit than keeping it in your savings account. The yield curve is a graph of yields compared to bond maturity times, and normally yields go up as you move to longer maturities.

The most watched elements of the yield curve are the yields on two-year and 10-year bonds. Historically, since 1969, when two-year Treasury bonds start paying out higher yields than 10-year bonds, inverting the usual relationship, it’s a sign of a recession coming. The indicator has predicted the last seven recessions, and the last time it inverted was in 2007, before the 2008 financial crisis and recession.

It’s believed that wary investors effectively bid down the price of the longer-term bonds as they look for a safe place to put their money. They also likely look to lock their money into high-paying bonds when they expect central banks like the Federal Reserve will soon cut future rates to stave off an impending recession.

Should everyone be worried?

While some pundits have said today’s inversion is a sign that it’s time to sell stocks, it’s still as hard as ever for everyday investors to time the market profitably. The yield curve began sporadically inverting before the last recession starting in 2005, but stock prices continued to rise for another couple of years before falling heavily in 2008 and 2009.

Data from Credit Suisse shows a recession historically begins an average of 22 months after the yield curve begins, according to CNBC. (Remember that the start of a recession, which essentially means a temporarily shrinking economy, also doesn’t necessarily overlap exactly with a stock market crash).

Former Federal Reserve Chairwoman Janet Yellen has sought to assure the public that the indicator doesn’t necessarily mean a recession. She told Fox Business Network she believes the economy is strong enough to avoid one, although she did say “the odds have clearly risen, and they are higher than I’m frankly comfortable with.”

Written by Investors Wallets

What VCs need to learn from the mistakes of WeWork and Uber

Will investors pay a premium for being green?