The yield curve is inverted. Here’s what that means, and what the implications are for the economy.

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An inverted yield curve for US Treasury bonds is among the most consistent recession indicators.
An inversion of the most closely watched spread — the one between two- and 10-year Treasury bonds — has preceded every recession since 1950.
Here’s what you need to know about the yield curve, why Wall Street cares so much about it, and why it’s been so dependable.
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Since 1950, all nine major US recession were preceded by an inversion of a key segment of the so-called yield curve.

Defined as the spread between long- and short-dated Treasury bonds, the yield curve turns negative when near-term Treasurys yield more than their long-term counterparts. The most closely watched section of the curve is the difference between two- and 10-year sovereign debt.

The movement is viewed as one of the most reliable recession indicators. And though it can take between up to 34 months for a recession to hit after the curve inverts, it’s among the first signs an economy is shrinking.

Analysts and investors alike place great value in the yield spread, but for those unfamiliar with the indicator, headlines can be confusing and vague.

Here’s everything you need to know about yield curve inversions, why people place such importance in them, and what they signal about the US economy.

What is the yield curve?

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US Treasury bonds measure their value in yield, a metric that represents how much an investor will make over the time they hold the bond. Typically, bonds with longer maturities — or those which require investors to wait longer before redeeming them — pay more in periodic coupon payments than those with shorter maturities.

The collection of all Treasury bond yields are measured with an upward-sloping curve that represents bond yields and maturity rates rising in tandem. Investors who think the economy will expand well into the future will earn a higher return-on-investment with a 10-year bond than if they bought a two-year bond.

What does an inversion in the curve mean?

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The yield curve is considered inverted when long-term bonds — traditionally those with higher yields — see their returns fall below those of short-term bonds.

Investors flock to long-term bonds when they see the economy falling in the near future. This increased demand drives long-term bond prices higher, and pushes yields lower accordingly. The higher the initial price of the bond, the less profit one makes when it reaches maturity.

Inversely, the lack of demand for short term bonds — caused by investors fearing an upcoming economic downturn — drives prices lower. Lower prices bring higher yields.

The most commonly feared inversion arrives when 10-year bond yields fall under two-year bond yields. This inversion leads the yield curve to slope downward from the three-month bond to the 10-year bond.

Why does Wall Street care so much?

REUTERS/Brendan McDermid

As mentioned above, a "2-10" inversion is regarded as one of the most consistent recession indicators for the US economy. It has preceded every recession since 1950.

Investors turn to bonds when stocks see increased volatility. But if too many investors are moving into long-term bonds, the collective sentiment measured with a yield curve inversion serves as a threshold for how Wall Street thinks the economy will perform.

Inverted yield curves arrive when long-term debt is deemed riskier than short term debt. Though many investors try — and fail — to time the exact moment to buy or sell assets to maximize their returns, the consensus represented by an inversion is historically correct, and foreshadows economic woes to come.

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