The yield curve shows the relationship between the maturities of bonds and their yields to maturity. In the normal case, short-term bonds yield less than long-term bonds, and the yield curve is upward sloping. Investors have to be content with lower returns when they invest for the short term. In the case of long-term bonds, the rate must be higher for the investors to achieve a greater ROI (Return on Investment).
When the yields of short-term bonds return more than long-term bonds, then the yield curves get inverted. An inverted yield curve shows a looming recession in the near future.
Usually, the value of bonds is measured by their value in yield. It is a matric of how an investor can buy or sell their bonds. In general, bonds with a higher maturity period pay more in returns than shorter-term bonds. The collection of all bonds yield is measured in an upward sloping graph. So, investors who believe that the economy will perform well will buy a 10-year bond instead of a short-term 2 years one.
Note − The curves' yield and inversion are all related to the yield generated by bonds. The inversion of the curve forecasts a recession.
When a bond inverts, it shows a lack of investors' confidence in short-term bonds. They fear that the near term is too risky to invest and they flock to longer period bonds for better returns. Investors prefer their money tied up for a longer future to get the returns back in the distant future, not in the shorter term.
As the investors flock to long-term bonds, the demand for them is higher. So, the interest rate on longer-term bills comes down. So, the longer-term yields must have higher yields than short-term bonds. This leads to shorter yields of short-term bonds. As the longer tenure bonds overcome shorter bonds, the curve inverts.
It has been seen that a common recession lasts for 10 months and the average waiting period for investors is 2 months. So, if an investor thinks that a recession is imminent, he/she will invest in bonds that pay in 2 months making them the hot cakes in the market. This leads to a falling in demands for other bonds increasing their yields. This inverts the curve.
Note − The most popular fear-invoking situation arrives when the 10-year bond yield goes down the 2 years old bond yield. This leads to an inversion of the common bond causing the reversal of trends.