Why does the yield curve invert?

There are moments in time when the yield curve inverts.  This article takes a look at when such events occur and what could possibly cause them.

The bond market exists of bonds of varying maturity: 3 months, 6 months, 1 year, 10 years, etc.  This timeframe describes how long you must hold the bond before you will receive the principal portion of the bond back.  For example, if I purchase a 10 year bond today that has a par value of $100 then I will have to wait 10 years to receive a $100.

The yield on a bond is a mathematical calculation that calculates how much money the bond will make for the holder.  If I purchase a 1 year bond today for $90 that has a par value of $100, which means I receive $100 a year later, then the yield on the bond is 11% since the bond will produce $10 on a $90 investment (10/90 * 100 = 11%).

 As bonds are traded their prices move up and down causing their yields to move accordingly.  Important to remember is that when a bond price goes up the yield of that bond goes down and vice versa.

The yield curve is a snapshot in time of bond yields with different maturities.  The length of the bond is on the x-axis and its yield is on the y-axis.  The most cited yield curve is the yields on the bonds of the US government.

Below is a picture of a typical yield curve where shorter term bonds have lower yields then longer term bonds.  Investors will usually require higher yields for longer term bonds since there is more uncertainty farther into the future.

Below is a chart of the yield curve from December, 2006.  This is an inverted yield curve since the yield on shorter term bonds is higher than the yield on longer term bonds.

The next chart shows the yield on government bonds of various maturities as a function of time.  The shaded areas are times when the yield curve either flattened or a portion of the yield curve inverted (i.e. longer term bonds with lower yields than shorter term bonds).  Of the 43 years shown on the chart, 11 of those years had a flattened or inverted yield curve.

I’ve read some articles where analysts speculate that the yield curve inverts because people are flocking to the safety of long term bonds driving long term bond prices up which in turn lowers the yield on long term bonds.  The chart tells a different story.  Notice that after 1982, when the yield curve flattens it is short term yields that rise sharply to match long term yields.  If investors were rushing into long term bonds then the chart would show long term yields going down sharply to meet short term yields but that is not what is happening.  In fact, longer term government bonds are a much smaller market than shorter term government bonds.  The chart below shows the maturity of the public US debt in 2006.  Only 25% of the debt had a maturity of 7 years or longer while 75% of the debt had a maturity of 6 or less years.  Thus the longer term bond market is much smaller than the short term market which would make it easier for those yields to change when investors rushed in yet as the yield history chart above shows it is the short term yields that change more rapidly.

So why does the yield curve invert?  Why does the short term yields change more than long term yields when the curve flattens or inverts?

I believe the inversion occurs because investors are moving out of short term bonds.  Many banks and money markets hold short term US treasuries as a way to earn interest when money is essentially idle.  Having money sit in US bonds is almost as good as cash.  Almost, but not quite.  Investors or banks move out of short term US debt for one of two reasons:  there are better yielding investments in the market or they need cash.  With the former the investor or bank could believe there are some great investment opportunities and so they move from safe US bonds to these investments.  This could explain the inversion in 1999-2000 when internet stocks were booming and 2006-2007 when real estate was booming.  Raising cash was the other reason the yield curve could invert.  Banks or investors may need to raise cash to cover for bad investments.  The bank or investor would sell their short term bonds to raise cash to help cover losses on bad investments.