The document explains the concept of an inverted yield curve, which indicates poor economic performance and is often a precursor to recession. It describes how long-term bonds typically yield higher returns than short-term bonds due to default risk, but during an inverted yield curve, this trend reverses, leading to higher short-term yields as investors anticipate economic downturns. Various factors, including historical precedents like the 2007 housing bubble, influence these changing perceptions among investors.

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Explanation: Inverted Yield Curve
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Explanation: Inverted Yield Curve
There is a lot of apprehensions associated with inverted yield curves and for good reason.
From a macro-economic perspective, an inverted yield curve predicts poor economic
performances shortly. This is the reason why in August 2019 when a yield curve inversion was
reported in the United States, the term recession was the most searched on Google in the country
(Mendez-Carbajo, 2019). The two concepts are often related because, an inverted yield curve,
more often than not, leads to a recession.
Bonds and Yields
To understand the yield curve inversion, one needs to first understand how US bonds
work and what yields refer to in this context. The Federal Government usually borrows money
through the selling of bonds. The same happens in large government corporations. This is done
when the expenses incurred are bigger than the revenues. The bonds are debt instruments that
entitle buyers to a government payout, or what is called coupons at specific maturity date.
Bonds vary in terms of maturity duration. There are lengthy bonds that can last up to 30
years. Some last up to 30 days (Benzoni et al., 2018). Bonds that take time to mature have higher
yields or returns compared to short-term ones. This is done to entice investors to buy the long-
term ones. Investors feel that longer-term bonds are best to invest in due to the high returns often
associated with them. The money they spend buying them is locked in the government and
cannot be redeemed until the maturity date is reached (Haltom et al., 2018). For this reason, these
bonds have high returns compared to short-term ones.
Another reason why long-term bonds earn higher yields is due to default risk. This is the
risk that a given bond will not be paid due to uncertainties that cannot be predicted in the long-
term future. To agree to take this risk, investors are promised high yields. This is why normal

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yield curves are positively sloped. An example of such a curve is as shown in Figure 1, as
reported by Christensen (2018) for the October 2018 Treasury Yield Curve.
Source: Mendez-Carbajo (2019).
The graph shows the earnings for bonds between 1 month and 30 years. Bonds that are
taken for a month earned the least interest at only 2.19%. The 30-year bond would have earned
an interest rate of 3.32% if taken in 2018. Thus, the yield curve on normal situations shows
increasing yields as maturity duration increases.
Yield Curve Inversion
The inverted yield curve assumes the opposite shape to a normal curve. Christensen
(2018) explains that such a curve represents an inverted relationship between maturity and
earnings made. This means that long-term US bonds are yielding less than short-term ones. To
explain that state of affairs, Mendez-Carbajo (2019) stated that is due to the expectations of the
buyers and sellers in the US government bonds market. Whenever buyers of the bonds expect a

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recession in the coming months or days, they tend to assign short-term bonds a high default risk
than long-term bonds. The seller is forced to agree because, in the bond market, the buyers have
higher bargaining power. they can choose to invest elsewhere. Thus, when they demand more
yields for a particular investment, the seller has to oblige. In the case of an inverted yield curve,
the buyers of treasuries expect higher yields to the perceived high default risk with short-term
bonds (Benzoni et al., 2018; Haltom et al., 2018). For this reason, the traditional perception of
maturity duration as the driver of yields is replaced. In such a time, buyers want to earn more
from short-term bonds than they would do normally because the risks are high.
The expectation of poor economic performances in the future can be driven by multiple
factors. In the recent past, the housing bubble of 2007 served as a lesson to many investors.
Today, when the precursor events that took place before the housing bubble burst occurs,
investors demand more yields from short-term bonds expecting a recession to hit the economy.
Other indicators include the anticipation of the Fed to offer low-interest rates due to a decrease in
economic activities such as the COVID-19 pandemic or other similar natural or artificial
disasters (Gräb & Titzck, 2020). These activities are highly likely to change the perception of the
future in investors which leads to the inverted expectations of yields from the short-and long-
term bonds. The resulting yield curve is inverted. It is called inverted because it is negatively
sloped, contrary to the normal yield curve. The inverted curve is as shown in Figure 2, reported
by Mendez-Carbajo (2019). From the US treasury yield curve of August 27th
, 2019.

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Source: Mendez-Carbajo (2019).
As shown in Figure 2, the inverted yield curve shows increased yields in short-term
bonds compared to long-term ones. In this particular case, the treasury experienced high yields of
2.07% for bonds maturing in one month. These were the highest earners with three-month bonds
earning 1.98%. Of particular interest were the 30-year bonds which were earning 1.97% yield
interest (Mendez-Carbajo, 2019). This was lower than what a three-month bond was earning in
that time and only slightly higher in yields than a 6-month bond. This shows that the buyers in
the bond market were demanding higher yields for their money when buying short-term bonds.
The shorter the maturity the better for investors during those times because the default
risk was lowest then. Yet another contradiction to the normal yield curve is the earnings between
two short-term bonds. The three-month bond earned less than a one-month bond because when
months constituted a higher default risk. The expectations were such that the government or the

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seller would in all likelihood fail to honor bonds that exceeded one month. In the normal yield
curve, the higher the default risk, the higher yields. In the inverted curve, the short-term bonds go
against this rule where investors are only willing to invest in the least default risk bond for the
highest yields (Benzoni et al., 2018). These are the main differences between the normal yield
curve and the inverted yield curve.

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References
Benzoni, L., Chyruk, O., & Kelley, D. (2018). Why does the yield-curve slope predict
recessions?. Available at SSRN 3271363.
Christensen, J. H. (2018). The slope of the yield curve and the near-term outlook. FRBSF
Economic Letter, 23.
Gräb, J., & Titzck, S. (2020). US yield curve inversion and financial market signals of
recession. Economic Bulletin Boxes, 1.
Haltom, R. C., Wissuchek, E., & Wolman, A. L. (2018). Have yield curve inversions become
more likely?. Richmond Fed Economic Brief, (December).
Mendez-Carbajo, D. (2019). Should we fear the inverted yield curve? Page One Economics®.