Investors who follow the markets have seen headlines in recent weeks about something called the “inverted yield curve.” For those less familiar with the phenomenon, an inverted yield curve is essentially a point on a chart where short-term investments in U.S. Treasury bonds pay more than long-term ones. And when it occurs, it’s generally regarded as a warning sign for the economy and markets.

What does this mean, exactly? If you are asking yourself this question, you’re not alone. So, let’s break down the inverted yield curve and the significance it could carry for you.

How bonds work

Before delving into the specifics of an inverted yield curve, it helps to understand how the bond market works. In this example of a yield curve, we’re focused on government-issued bonds referred to as U.S. Treasury securities.

Investors who purchase Treasury bonds are lending money to the government. In return, they earn interest, or a yield, on that security. In a typical economic environment, investors earn lower yields on shorter-term bonds and higher yields on longer-term bonds. This reflects an expectation that the longer the lending period, the higher the risk.

The normal shape

The proverbial “yield curve” is drawn by plotting out current yields on Treasury securities of various maturities. The shortest maturities are on the left-hand side (one-month, two-month, three-month and six-month). The scale continues plotting yields for one-year, two-year, five-year, seven-year, 10-year and 20-year yields, ending on the far-right side of the scale with 30-year bond yields.

If we assume that investors typically require higher yields to invest in bonds with longer maturities, then under normal circumstances the yield curve is upward sloping. For example, at the end of October 2018, yields on Treasury securities ranged from 2.30% for one-month bonds to 3.39% for 30-year bonds, with the curve rising steadily upward at each maturity level.

Changes

In recent months, we’ve seen a change in the slope of the yield curve. It has generally flattened out, with little differentiation in rates between shorter-term and longer-term Treasury securities.

Most notable to the markets was an inversion between the yields on two benchmark securities, the two-year Treasury and the 10-year Treasury. On Aug. 27, yields on 10-year Treasuries fell to 1.49%, lower than the 1.53% yield on two-year Treasuries. Even the one-month Treasury security paid a higher yield (2.07%) than the 30-year Treasury bond (1.97%).

Raising investor concerns

Yields on Treasury bonds are driven primarily by demand for those bonds. When yields on longer-term securities drop low enough to result in an inverted yield curve, it indicates that many investors are seeking to buy those securities.

The conventional wisdom is that investors who choose to accept low yields for longer-term bonds anticipate that a recession may be approaching. If a recession occurs, the Federal Reserve is likely to cut the short-term interest rates it controls. Often when that occurs, yields on other types of bonds decline as well. So those investing in long-term bonds may anticipate Federal Reserve rate cuts and want to lock in higher rates on longer-term bonds before they drop.

Is it a reliable indicator?

There is plenty of speculation that the inverted yield curve could signal a coming recession. While a recession has often followed a yield curve inversion, such an occurrence is not set in stone. What’s more, it is not a reliable indicator of the exact timing of a recession. In fact, no such indicator related to timing of the economic cycle appears to exist.

Yet it is worthwhile to note that we are in an unusual environment for fixed income securities given the inverted or flattened shape of the yield curve. There appears to be a fair amount of uncertainty about the near-term outlook for the economy and markets. It may be an opportune time to review your current investment strategy and consider whether any changes are appropriate.

Source: U.S. Department of the Treasury, “Daily Treasury Yield Curve Rates,” (https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield)

Randy Groff, ChFC, CLU, CRPC, is a financial adviser with Ameriprise Financial Services, Inc., in Marshall.