Financial and Monetary Systems

What does an inverted yield curve look like and what does it signal about an economy?

An inverted yield curve is when interest rates on long-term bonds fall lower than those of short-term bonds.

An inverted yield curve is when interest rates on long-term bonds fall lower than those of short-term bonds. Image: REUTERS/David Gray

James Eagle
Writer, Visual Capitalist
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  • The yield curve is a line chart that plots interest rates for bonds that have equal credit quality, but different maturity dates.
  • Yields are normally higher for bonds that mature over longer periods, as investors are rewards for holding bonds for more time.
  • An inverted yield curve is when interest rates on long-term bonds fall lower than those of short-term bonds.
  • This can be a sign of a coming recession – an inverted yield curve has emerged roughly a year before nearly all recessions since 1960.
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Visualizing (and understanding) an inverted yield curve

For a few months in 2019, the yield curve inverted and warned of a potential recession.

Towards the end of 2021, it happened again. And throughout 2022, the inverted yield curve has looked more and more extreme. So what does an inverted yield curve look like, and what does it signal about an economy?

The above visualization from James Eagle shows the yield curve from November 2021-2022 using eurodollar futures yields—which serve as an indicator for the direction of the yield curve.

What denotes an inverted yield curve?

Generally speaking, the yield curve is a line chart that plots interest rates for bonds that have equal credit quality, but different maturity dates.

In normal economic conditions, investors are rewarded with higher interest rates for holding bonds over longer time periods, resulting in an upward sloping yield curve. This is because these longer returns factor in the risk of inflation or default over time.

So when interest rates on long-term bonds fall lower than those of short-term bonds, it results in an inverted yield curve.

The worrying trend is that an inverted yield curve in key government securities such as U.S. Treasuries can often foreshadow a recession. For every recession since 1960, an inverted yield curve took place roughly a year before, with just one exception in the mid-1960s.

This is because the yield curve has steep implications for financial markets. If the market predicts economic turbulence, and that interest rates will fall in the long term, investors flock to buy longer-dated bonds.

Eurodollars: A Hedging Tool

Let’s now look at eurodollar futures, as seen in the above visual.

Eurodollars are not to be confused with euros, the currency in the European Union. Instead, they are U.S. dollars held in term deposits outside of the United States. Originally it applied to accounts specifically in Europe, hence the “euro” prefix.

The video above charts eurodollar futures, which allow banks and companies to secure interest rates today for USD funds they plan to lend or borrow at a future date. In short, the yields on these futures can tell us how banks and companies around the world feel about interest rates—and economic strength.

How the yield curve’s inversion has gotten more extreme

The animation above clearly shows how the yield curve hasn’t just inverted, it has become more severe:

A table showing how yield curve's inversion has become more severe.
December 2022 eurodollar futures yields in November were much higher than 2024 yields. Image: Visual Capitalist.

As the above examples show, yields on March 2023 eurodollar futures contracts have continued to rise over the course of the year—from 1.3% to 5.0% by November.

Meanwhile, March 2024 eurodollar futures yields over the same time period began higher than their 2023 counterparts but eventually became eclipsed.

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And more immediately, December 2022 eurodollar futures yields in November were much higher than 2024 yields. Not only does this indicate investor pessimism, it suggests that the market expects interest rates to fall by 2024 and for inflation to decline.

The Flip Side

On the other hand, market expectations of looser monetary policy in the future could miss the mark.

“I suspect the market is getting a little ahead of itself in terms of pricing in cuts… Central banks have still been talking about holding rates at higher levels for longer.” – Andrew Ticehurst, rates strategist for Nomura Inc.

As 2023 unfolds, investors will be watching closely to see if the inverted yield curve indeed serves as a recession harbinger, and the wider consequences of this potential outcome.

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