What is an inverted yield curve?

To understand what an inverted yield curve is, you must first understand one of the most basic financial asset classes out there: Bonds.

A bond is like an IOU given to you by a bank. When you lend the bank money, it’ll give you back that same amount at a later time along with a fixed amount of interest.

For example, if you bought a two-year bond for $100 with a 2% annual return on it, that means you’ll get $104.04 back after two years (this accounts for compounding).

Yes, that’s a low return rate. However, bonds have a number of benefits that justify the small rate of return:

They’re an extremely stable investment. This is especially true when it comes to government bonds. The only way you can lose your money with them is if the government defaulted on its loans — which the U.S. government has never done.

They’re guaranteed to have a return. This means that you’ll know exactly how much you’re getting on your ROI when you purchase a bond.

Longer investments yield higher returns. The longer you’re willing to wait on your bond typically means that you’re going to have higher return rates. I say typically because there are exceptions to this (Hint: It has to do with what we’re talking about right now).

And when people refer to inverted yield curves, they’re typically referring to the yields on U.S. Treasury bonds, or bonds guaranteed to investors by the U.S. government.

The Fed Is Going to Buy Bonds Again. It’s Not a Stimulus Effort.

The Federal Reserve will resume the expansion of its balance sheet soon. Just don’t call it quantitative easing.

Following a sudden rise in overnight bank funding costs in September, Fed Chairman Jerome Powell said Tuesday that the central bank will begin increasing its securities holdings to “maintain an appropriate level of reserves.” This should be viewed as a technical adjustment and different from the large-scale asset purchases the central bank undertook to stimulate the economy following the financial crisis, he said in a speech to the National Association of Business Economists in Denver, according to the text.

This move would be in keeping with the Fed’s “ample reserve” operating policy established in the wake of the financial crisis, in which the central bank controlled the federal-funds rate—its primary policy target—by establishing the interest it pays on bank reserves. Before the financial crisis, the Fed would control the fed-funds rate through open-market operations—the purchases and sales of securities—to maintain a scarcity of reserves.

Some market observers are calling the Federal Reserve’s recent commitment to buy billions of dollars of U.S. Treasury bills QE4—the start of a fourth round of so-called quantitative easing meant to boost a flagging economy.

The underlying problem was a systemic shortage of money. Fed officials wrongly believed the banking system was flush with more reserves than it needed. In reality, the system was operating on a knife edge where small changes in the quantity of reserves generated large changes in price. 

Inverted Yield Curve Suggesting Recession Around The Corner?

If we look at the data past yield curve inversions in the US. The difference between the 10-year and 2-year Treasury yield (10Y2Y) going back to 1976.

Notice that before almost every recession, the yield curve inverted and then steepened.

And how often did the yield curve invert and no recession followed within two years of the first inversion? 

Zero.