Why is an inverted yield curve a problem?

Question

Immediately preceding the worst of the financial crisis, my professors all pointed out to me that the yield curve had inverted -- short-term yields were more risky than 20-year or 30-year Treasury securities. My professors all seemed nervous about this.

Aside from such a situation being generally counter-intuitive, why was this viewed so negatively? What kind of effects does this have, in a more macro sense?

Answer 1

Nano answer: declining yield curve is a symptom that the market expects the economy to worsen.

---

Short answer: yield curve is built on expected future interest rates. Yield curve will be downward sloping if you expect interest rates to fall in the future. Interest rates fall because the central bank react to worsening economy.

So if the yield curve is downward sloping it means the market expects the economy to worsen to the point that the central bank will have to intervene.

Answer 2

To explain why a negative sloping yield curve is bad, you have to start with a theory of the yield curve.

The dominant theories for the term structure of interest rates are the rational expectations, liquidity preference, and market segmentation. (The first two theories are quite compatible with each other and have more standing so let's assume that view.)

Generally, we expect longer-term maturities to have correspondingly higher yields because the investor must bear more risk (inflation risk, bond price risk, interest rate risk, liquidity risk, credit risk). So it is indeed "abnormal" to observe an inverted yield curve -- why would an investor hold longer-term maturities in the face of these risks? The answer is that that long-term investors expect the term-structure of rates to drop even further. These expectations can be measured in the implied forward rates of the term structure.

What is the negative slope mean for economic growth? The negatively sloped yield curve is a function of the short-rate and longer-rates. The Federal Reserve targets the short-rate thru open market operations (purchases and sales of short-term treasury bills). The Fed may raise the short-rate substantially to limit credit growth.

In this world, bank have less incentive to lend long and fund capital or residential investment projects since banks can lend short and capture a higher rate. This reduces the pace of credit growth and the number of new projects financed by debt. Also, the risk-free rate is an asset class that competes with equities and other asset classes (housing, gold, etc.). The higher the short-term rate the less speculation in other asset classes which can lead to bubbles bursting.

Note that banks will still continue to issue loans at longer maturities, however, they will focus on higher quality investment-grade credits. Firms that have marginal access to credit may experience re-financing difficulties and may not benefit from lower long-term risk free rates since credit spreads typically widen in a recession.

Also, there is research showing that long-term treasury rate is a proxy for nominal economic growth. If the long-rates are very low and the short-rate is high, the bond market is anticipating weak economic growth and future Fed rate cuts.

Answer 3

Theoretically, a rising yield curve is compensation for the additional duration risk.

An inverted yield-curve is saying that the market thinks that:

Next-year's figures for: growth plus inflation
is less than
Ten years' time's figures for: growth plus inflation

Which means that expectations are either of a recession (some negative economic growth; and as far as the indicators are concerned, at least two consecutive quarters of negative growth), or that inflation in 10 years time is expected to drop relative to what's in the rates now.

The US had yield-curve inversions for less than three months in 1995 and 1998, without immediate subseequent recession, so it can be a false signal. The US yield curve inverted, when, mid 2005? So wasn't a reliable signal of "when". The yield curve inverted in 1966, and was not followed by recession. But the three recessions before that were not preceded by a yield-curve inversion; the 1990/1 recession wasn't either.

The UK yield curve spent a few years flat / inverted, in the noughties, during economic boom times (driven by high demand from pension funds for long-dated gilts).

So an inverted yield curve can be an unreliable indicator of recessions.

Answer 4

An inverted yield curve basically means that interest rates will be higher for the coming year than for the years following.

That means that entities that need do borrow for short term purposes will do so at a greater cost that those borrowing for the long term. That is an unusual and "unnatural" relationship. All other things being equal, that will dampen economic activity in the coming year, likely producing a recession.

An interest rate "curve" functions something like a weather report. In the case of a inverted yield curve, it is forecasting "stormy weather just ahead."

Answer 5

Samuelson once quipped that the yield curve had successfully predicted 9 of the last 5 recessions.

Explanations for why the yield curve inverts have been covered adequately above. But what does it mean for the economy? For the yield curve inversion to predict stock market performance enough to make an actual decision, the bond market would have to be more efficient than the stock market (ignoring carry costs, etc.). That seems like a pretty strong assumption.