Thought to be the most uncommon of the well-known shapes, inverted yield curves are considered to be a sign of a recession or other type of economic slowing. The shape indicates high rates of interest for short-term bond scenarios.
Throughout history, the existence of an inverted yield curve is preceded by several raises in short term interest rates by the central bank of a given government. When the bank wishes to get a handle on positive rates of inflation in the general economy, they will likely increase short-term rates in order to put a damper on economic growth.
Inverted yield curves demonstrate bond markets in which investors see a higher reward in buying short-term bonds than in vehicles with longer maturities. This is also a time when individuals as well as business enterprises will experience potential difficulties in financing daily operations as well as long-term investment strategies. The outcome is a slowed economy overall.
Given that an inverted yield curve is seen as a precursor to a slowing or a recession in the economy, investors use the forecast when considering their stock market projections.
Not only should investors pay attention to the yield curve’s shape, its steepness and overall interest rate levels, they need to pay attention to true interest rates. The inverted yield curves below are instructive.
While both curves are inverted and thus forecast a slowdown in the economy, the bottom one suggests a drastically lower projection for positive inflation in the future. This could predict that future economic bounce-back will not be very robust, and the economy is unlikely to return to extremely high levels of inflation.
The longer-term impact on future asset price levels in the realms of real estate, stocks and more is very real.
Investment market participants must also note that yield curves are meant to be tools to help forecast broad economic cycles and trends, not those of the stock market. Stock cycles can and have historically run the gamut between being lagging and preceding indicators.
Finally, provided that inflation stays in the positive category, it is seen as typical for short-term bond rates to stay lower than those for long-term bonds.
However, if deflation occurs in the same way it did in the 19th and early part of the 20th century in America, an inverted or flat yield curve may assume a normalized status.