So you’ve been reading an article or heard it mentioned on TV, but what the heck is an inverted yield curve and why do we really care? The short answer is that historically, every time there is an inverted yield curve situation, a recession is quick to follow.
Here’s the book definition: an inverted yield curve represents a situation in which long-term debt instruments have lower yields than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered a predictor of economic recession.
Let me try to put this in simpler terms. Let’s say, I wanted to borrow $100 from you and asked you how much return you would want for 6 months, 1 year, 10 years, and 30 years. Like most people, you would want a higher yield (higher interest) for the longer periods where I borrowed your money, right? So you might tell me you want me to give you back $105 for 6 months (10% APR), $120 for 1 year (20% APR), $400 for 10 years (30% APR), and $1300 for 30 years (40% APR). This is what is called a “normal” yield curve where the longer term debt has higher returns than the shorter term debt.
Now imagine where someone else offers $105 for 6 months (10% APR), $107.5 for 1 year (7.5% APR), $150 for 10 years (5% APR), and $175 for 30 years (2.5% APR). Now that just looks odd, doesn’t it? But this is what we call an inverted yield curve where the return on the longer term debt is less than shorter term debt. And now you know why an inverted yield curve is a very rare event.
The reasons behind why an inverted yield curve happens is a much longer conversation and we’ll write up something about it if there is enough interest, but now you’ve been introduced to what it is and hopefully have a better idea of why it is such a unique situation.
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