Does an inverted yield curve spell trouble?

The inverted yield curve has been in the news a lot lately. What is it, and why is it important?

What is a yield curve? It’s a line on a graph showing the interest rates of U.S. Treasury debt of various maturities over time. The typical maturities charted are 3-months and 2-, 5-, 10- and 30-years.

Generally, short term rates are lower than longer term rates. This is because the shorter term is easier to predict than the longer term. For example, the weather is easier to predict for this afternoon than it is for next month. When investors lock up their money for longer periods of time, they want higher rates to compensate them for that risk. For this reason, the yield on a 10-year note is generally higher than on a 3-month bill.

Sometimes the 10-month yield dips below the 3-month. This happened at the end of March.

Investors became concerned because an inverted yield curve is generally a sign of an upcoming recession, which typically occurs 1-2 years after the inversion occurs. Recent slowing growth in Europe, China, and potentially, the U.S., sparked recession fears.

An inverted yield curve also indicates the market believes the next move by the Federal Reserve may be to lower rates, rather than raise them.

What should you do with your portfolio? Review your holdings to make sure you haven’t taken on more risk than you are comfortable with. An inverted yield curve generally needs to last for months, rather than days, before it is a reliable indicator of a potential recession, so this isn’t a sign of an impending meltdown. But it may mean there is slower economic growth ahead. 


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