What is an inverted yield curve?

I’ve been hearing a lot about the inverted yield curve on Bloomberg radio the last couple of days so now is the best time than any to mention it. 

An inverted yield curve occurs when long-term interest rates have lower yields than short-term interest rates.  It’s actually a pretty rare occurrance, the last being about 5 years ago.  What does this say about the economy? History says that there could be an oncoming recession. 

Here’s a little more from investopedia:

These yield curves are rare, and they form during extraordinary market conditions wherein the expectations of investors are completely the inverse of those demonstrated by the normal yield curve. In such abnormal market environments, bonds with maturity dates further into the future are expected to offer lower yields than bonds with shorter maturities. The inverted yield curve indicates that the market currently expects interest rates to decline as time moves further into the future, which in turn means the market expects yields of long-term bonds to decline. (Remember that as interest rates decrease, bond prices increase and yields decline.)

You may be wondering why investors would choose to purchase long-term fixed-income investments when there is an inverted yield curve, which indicates that investors expect to receive less compensation for taking on more risk. Some investors, however, interpret an inverted curve as an indication that the economy will soon experience a slowdown, which causes future interest rates to give even lower yields. Before a slowdown, it is better to lock money into long-term investments at present prevailing yields (because future yields will be even lower).

What does an inverted yield look like compared to a normal yield curve? (Click thumbnail for full-size image)

Left: Inverted Yield Curve    Right: Normal Yield Curve 

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