Yield curve inversion

A condition of the yield curve rather than an event in itself. Because lending for longer normally costs more, the slope between two maturities is usually positive, and an inversion is that slope turning negative. It is measured as a spread between two named points, which is why the inversion has no single date: the ten year yield less the two year and the ten year yield less the three month are the two pairs most often quoted, and they have historically crossed zero months apart.

The mechanism most often given is expectation. The near end of the curve is held close to the policy rate in force today, while the far end prices an average of the rates expected over many years, so a market expecting policy to be eased later prices the longer maturity below the shorter one. A second route to the same shape is demand: heavy buying of long dated securities compresses the term premium and flattens the far end without anything being expected of policy at all. The two produce an identical picture, which is the first reason the shape is harder to read than its reputation suggests.

In the United States an inversion has preceded each recession since the nineteen sixties, and that record is why the shape is watched. The caveats are as much a part of the record as the record is. The number of recessions in the sample is small, so the evidence is thinner than a long history implies. The interval between an inversion and a recession has been long and variable, running beyond a year in several cases, so the shape has never functioned as a schedule. There has been at least one inversion not followed by a recession. And the relationship is weaker where central bank purchases have compressed the term premium, since the shape then carries a different cause. Why it should work at all is disputed: one account is that the curve simply reports expectations that turn out to be correct, another is that a flat or inverted curve compresses the margin banks earn by funding long lending with short deposits and so tightens credit directly. Neither account is settled, and both are held by serious people.