Inverted Yield Curve: Meaning, Implications& What is tells an Investor

Whether you track the economic cycles around the world or not, recession is a phenomenon most of us are aware of.Historically speaking, the recession may lead to inflation and it may be a common practice to raise interest rates to tame inflation. However, opinions have emerged from the countriesentering intothe recession with a possibility of easing monetary policy. But how? Well, one of the trends that have fueledthis discussion is the inverted yield curve. This article will explain the concept of yield curve inversion and what it can tell an investor who has invested in mutual funds and other debt instruments.

What Is an Inverted Yield Curve?

A yield is the return realised from a bond investment, while a yield curve displays the results of bonds with different maturities. Typically, the yield curve tends to be upward-sloping, meaning that yields from short-term bonds are lower than those from long-term bonds. However, there could be instances when the yield curve’s shape gets inverted.

An inverted yield curve is one where the yields for the short-term are higher than the yields of the long-term. The assumption is that the underlying bonds have the same credit quality but different maturity periods. An inverted yield curve is also called a negative yield curve. A yield curve inversion is generally considered rare, but they are known to happen.

Understanding Inverted Yield Curves

One investing principleis the assumption that long-term instruments often offer better returns than short-term investment avenues. However, much depends on the growth outlook for gross domestic product (GDP) and other economic factors. In bonds specifically, it is assumed that the longer the debt instrument maturity, the higher the risk, which gets reflected in higher yields. Typically, across the world, a 10-year government bond is taken as the benchmark to plot the yield curve.

What are the implications of an inverted yield curve?

Bond prices are inversely proportional to interest rates or yields. When the demand for long-term bonds increases, the prices of these bonds rise, and the results consequently fall. Demand for long-term government bonds might increase because investors perceive it to be a safe asset class, and this could occur when a recession seems imminent.

History has shown that in the last 50 years, every yield curve inversion has been followed by a slowdown or recession. Thus, economists and investors have often considered this indicator significant. If a yield curve that was positive before gradually transforms into an inverted yield curve with a downward slope, it indicates that interest rates or yields in the long term are likely to fall. Since a recession also coincides with a fall in interest rates (as a measure by governments to kick start a sluggish economy), a negative or an inverted yield curve more often not suggests the likelihood of a recession.

Additional Read: What is Yield to Maturity?

What can an inverted yield curve tell an investor?

A yield curve inversion could tell an investor that a slowdown in economic performance or a recession is likely. Thus, if a country's economic health looks robust, which could translate into good GDP growth, the yield curve will slope upwards. However, if the economic growth has entered a slowdown period and future indicators signal a further weakening of GDP, this could translate into an inverted yield curve. Since the behaviour of debt instruments is closely linked with a country’s economic health, an investor can adjust his/her debt portfolio, including any investment made in mutual funds or debt funds, if necessary.

To conclude…

Many factors and indicators are at play that can influence the performance of investments. One such indicator is the inverted yield curve, which suggests a recession or slowdown is possible. In any economy, periods of boom are likely to be followed by periods of recessions. If you are a long-term investor, the impact of either booms or busts is expected to get reflected in the performance of your portfolio as well. It is called riding out the entire length of the economic cycle. Ideally, if your portfolio comprises investments with strong underlying fundamentals, it is a matter of sticking it out through the recession. Thus, like any economic indicator, an inverted yield curve should be looked at in collaboration and should ideally not become the sole factor on which you base your investment decisions.

Additional Read: YTM-vs-Coupon rate