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What Is An Inverted Yield Curve?

The front end of the yield curve is inverted, which has garnered a lot of press lately. Before diving into the implications of an inversion, a short primer on the yield curve and what an inversion looks like. The US Treasury yield curve is simply a graphical representation of where US Treasury bonds are trading. 

Looking at this morning's yield curve (see image above), we can see that five year bonds are yielding 1.817%, ten year bonds yield 2.081% and thirty year bonds yield 2.597%. This upward sloping portion of the curve is very common, although the levels and slope change throughout time. What is unusual is the front part of the curve, which is "inverted." Notice that three month bonds yield 2.19%, but one year bonds only yield 2%. And two year bonds only yield 1.82% with three year bonds yielding even less at 1.762%! This is neither common nor intuitive. Borrowers (the US government in this case) generally expect that longer-term loans carry a higher interest rate. Similarly, investors generally demand higher interest rates for longer-term commitments. 

There are many theories on what drives the shape of the yield curve (which is way beyond the scope of this post), but an inverted curve is generally interpreted as a warning sign. Our next post will examine the empirical evidence for this interpretation as well as the practical implications for investors.