The Yield Curve Just Inverted: Should Investors Be Worried?

The "yield curve" is a term used to describe the various interest rates paid by different maturities of fixed-income investments. It's been in the news quite a bit recently, and not in a good way.

Something known as an inverted yield curve occurred this week, and it's happening in a specific way that we haven't seen since just before the Great Recession. That's a period many investors don't remember fondly.

To better understand why this situation has some concerned, here's a primer on what an inverted yield curve is, why it is considered to be a sign of trouble for investors, and what this particular yield curve inversion means to you.

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What is an inverted yield curve?

A yield curve refers to the interest rates, or yields, paid by different maturities of similarly rated fixed-income securities. While the term can technically refer to any type of fixed-income investments, it is most often used in reference to Treasury securities. When plotted on a grid, the points for each maturity rate form a line that curves; hence the name.

There are three main types of yield curves -- normal, flat, and inverted.

In a normal yield curve, Treasuries with longer maturity lengths have higher yields. For example, in a normal yield curve, the 2-, 5-, and 10-year Treasuries might yield 2%, 2.5%, and 3%, respectively.

A flat yield curve means that Treasuries of differing maturity lengths have roughly the same yields. If the 2-, 5-, and 10-year Treasuries are all yielding about 3.5%, we'd say that the yield curve is flat. Similarly, if Treasury yields on a normal yield curve all begin to gravitate toward a certain yield, we may say that the yield curve is flattening.

Finally, an inverted yield curve means that shorter-maturity Treasuries have higher yields than longer-maturity varieties. Inversions can happen in a variety of ways, but the 2- and 10-year Treasuries inverting is generally considered the standard form.

Recently, the three-month and 10-year Treasury yields inverted for the first time since mid-2007, as you can see on this chart of Treasury yields from mid-morning on March 26, 2019:

Data source: CNBC. Yields as of March 26, 2019, at approximately 11:30 a.m. EDT.

Why do investors care about yield curve inversion?

For some economists, an inverted yield curve is considered a predictor that recession is coming soon. We generally see an inverted yield curve before a recession occurs, although a recession doesn't necessarily occur every time we see a yield curve inversion. It's not a perfect predictor. And when a recession does follow a yield curve inversion, there's no way to predict when the recession will begin, although it's typically within about 18 months if it does happen.

The three-month and 10-year yield inversion we're currently seeing is especially troubling to investors. As mentioned, we haven't seen such an inversion since 2007, and the Great Recession followed soon after.

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Should you be worried?

An inverted yield curve isn't a perfect predictor of recessions. In fact, a different part of the yield curve inverted in December, and the market proceeded to rebound sharply as soon as fears subsided. Plus, the 2-year and 10-year yields aren't inverted, and this is often thought of as the main recession-predicting inversion.

Many economists are saying that the current drop in 10-year Treasury yields is due to factors such as global (non-U.S.) economic headwinds like Brexit concerns and the slowdown in China, as well as the dovish Federal Reserve outlook for interest rate hikes. It's not necessarily the result of a serious weakening in U.S. economic fundamentals. Most economists agree that the U.S. economy is slowing, but few are predicting a recession, even after this latest inversion.

The bottom line is to take the current yield curve inversion as just one of several potential economic indicators to watch. It's worth keeping a closer eye on GDP growth, inflation, and unemployment to see if they also indicate trouble. But this inversion is certainly not a reason to panic and adjust your investing plans all on its own.