Ask a Fool: What Is an Inverted Yield Curve, and Why Should I Care?

Q: I've seen experts on the financial news expressing concern about the yield curve and how it's "inverting." What does this mean, and why is it a bad thing?

The yield curve refers to the interest rates paid by different maturities of fixed-income instruments, particularly Treasury securities. For example, the yield curve may consist of the three-month, two-year, five-year, 10-year, and 30-year Treasuries.

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Generally speaking, the longer a bond's maturity length, the more interest you can expect, all other factors being equal. For example, a two-year Treasury yield of 2.5%, a five-year yield of 3%, and a 10-year yield of 3.5% could be considered a healthy yield curve.

On the other hand, a flat yield curve occurs when Treasury yields are roughly the same for different maturities, which is where we are right now. This is worrisome to many investors because a flat yield curve is often one step before an inverted yield curve -- when shorter-maturity bonds are actually paying more than longer-maturity ones.

An inverted yield curve is seen as a predictor of recessions (although not a perfect one). A textbook yield curve inversion occurs when the two-year and 10-year Treasury yields invert, but other inversions are possible as well. For example, as I write this, the two-year and five-year Treasury yields are inverted, which is thought to be at least partially to blame for the recent stock market volatility.

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