Inverse yield curve explanation

Inverse Yield Curve Definition: What is it?

Not only with banks, but also in trading, investors often rely on interest-bearing investments. As a rule, the interest rate increases with the duration of the investment. This is called the yield curve. However, there are also a few cases of an inverse yield curve. The following article explains exactly what this is, how it can occur and what the consequences of an inverse yield curve are.

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What is an inverse yield curve?

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With cash investments, the investor refrains from using the money in any other way. There is also a greater risk of inflation and interest rate changes in the long term. Therefore, the investor basically receives compensation for it in the form of interest. This phenomenon exists not only in banks, but also in the stock market.

These interest rates rise over time, i.e. depending on the remaining term. Accordingly, a rising yield curve is the rule. This means that the interest rate for securities with a long remaining term is higher than for securities with a short term.

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In rare cases, however, there may also be a flat interest rate curve. This means that the interest rate hardly differs despite different maturities. In extreme cases, interest rates even fall with longer maturities. This is referred to as an inverse interest rate structure or an inverse market.

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The inverse yield curve is the exact opposite of the classic yield curve. It arises in anticipation of falling interest rates on long-term investments. Investors switch from short-term to long-term investments because they want to secure the high interest rates that still exist today. As a result, the price of so-called long-dated investments rises and their yields fall. The price of short-dated assets, on the other hand, falls, while their yields rise. Thus, the normal interest rate and yield structure is reversed and the curve becomes inverted.

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Inverse interest rate structure – definition

If the interest rates on long-term investments are lower than the interest rates on short-term investments on the capital market, this is referred to as an inverse interest rate structure. Normally, the situation is exactly the opposite.

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What does an inverse interest rate structure mean?

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The case where assets with shorter maturities have a higher interest rate than assets with longer maturities occurs quite rarely. Nevertheless, economists and central bankers regard the inverted yield curve as a reliable warning signal of an impending recession. This relationship can often be observed empirically.

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Interest rates usually fall in times when the economic situation deteriorates. Both companies and consumers behave more cautiously and the demand for credit decreases. As a result of the fall in demand, the price or interest rate of credit also falls. The inversion of the yield curve is an indication of the expected deterioration of the economy. It is also usually accompanied by falling share prices on the stock market – which means that the market becomes bearish.

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Spread model as orientation for an impending recession

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The so-called spread model is based on the findings of Estrella and Hardouvelis (1991). The predictions for individual recessions have an amazingly high hit rate. The forecast for the following year is based on the current difference between the interest rates of 2-year and 10-year US government bonds. Before the recession occurs, the probability then increases exponentially.

The value 0.4 represents the threshold value. If the probability is above this value, this is a reliable sign of an impending recession. The only exception so far were the years before the dotcom crisis. Nevertheless, the spread model is both relatively reliable and robust. Choosing other maturities – for example 3 months instead of 2 years – yields similar results.

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Recession 2020 as an example

Since the early 1980s, there have been six recessions in the U.S. that were reliably forecast – including the Corona pandemic. For example, an inverted yield curve occurred in August 2019, with the 2-year rate several days higher than the 10-year rate. Accordingly, the model’s forecast rose, but the market neglected it. Instead, it paid more attention to other economic indicators and the booming US economy at the time.

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About a year later, the recession finally occurred. Although the coronavirus played an important role in this, which could not have been expected a year earlier, the model proved its validity in this case as well.

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Criticism of the spread model

The interdependence of events or processes can go both ways. On the one hand, the inverted yield curve can trigger a recession if interest rates on short-term investments are raised. As a result of tighter monetary policy, economic growth is dampened and a recession occurs.

On the other hand, a recession can also be triggered by investors’ assumptions. If investors expect interest rates to fall, they tend to position themselves in longer-dated investments. The high demand for long-dated assets can result in an inverted yield curve. Accordingly, the yield curve is not the cause but the result of a presumed recessionary development.

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A certain degree of caution is therefore required when interpreting the probability forecasts using the spread model. Although there is a statistical correlation, the causes of a recession actually occurring are usually deeper. Interest rate movements are only one factor. Accordingly, not every inverse yield curve is automatically followed by a recession.

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Conclusion: Reliable alarm signal for future recession

When an investor invests money, he foregoes using that money in some other way. In return, he receives interest – not only from banks, but also on the stock market. As a rule, these interest rates rise the longer the term. If the opposite is true, it is called an inverse interest rate structure. It can occur either in anticipation of falling interest rates on long-dated investments or when interest rates on short-term investments are raised. The inverse yield curve is a robust and reliable warning signal that a recession is imminent.

The spread model according to Estrella and Hardouvelis (1991) graphically represents the probabilities for such a case – and with an amazingly high hit rate. Even the recession of 2020 due to the Corona pandemic was predicted, although the virus was not even known a year earlier. Although there is a statistical correlation, the causes of recession usually lie deeper. Accordingly, some caution should be exercised in interpreting the model.

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Frequently Asked Questions:

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What is an inverse yield curve?

For an investment, an investor usually receives compensation in the form of interest. After all, he waives the right to use the money elsewhere. As a rule, the interest rate increases as the investment period increases. That is, the longer the investor puts his money to work, the higher the interest he receives in return. However, with the inverse yield curve, the opposite is true. Here, the interest rate on long-term investments is lower than the interest rate on short-term investments. The ordinary yield curve is therefore inverted.

What are the consequences of an inverse interest rate structure?

An inverse yield curve is considered by economists and central bankers to be a reliable warning signal of an impending recession. Falling interest rates usually occur at times when the economic situation deteriorates. The demand for credit declines and, accordingly, so do the prices or interest rates on it. The inverse interest rate structure is usually accompanied by falling stock prices in the stock market and the market becomes bearish.

How can an inverse yield curve arise?

An inverse yield curve can arise, for one thing, when interest rates on short-term investments are raised. The tighter monetary policy dampens economic development and a recession occurs. Second, an Inverse Yield Curve can occur when investors expect interest rates to fall. In this case, investors shift their short-term investments into long-term ones, as they want to secure the interest rates that are still high today. As a result, the price of so-called long-dated investments rises and interest rates fall. Thus, the normal interest rate structure is reversed and the curve becomes inverted.

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