Inverted Yield Curve Implications

Yield curve represents the relationship between long-term and short-term Treasury interest rates. Generally, if the economic conditions are within normal ranges the interest rates in the long-term debt should be higher than those on the short-term debt.

This relationship is absolutely logical since the longer time horizon means that investors and lenders are exposed to higher levels of risk than the risk associated over the short-term. The longer time horizon may include events that can seriously affect the returns of lenders.

This relationship between short-term and long-term interest rates can be observed in the products offered by banks. For example, a normal savings account returns its holders lower interest, whereas a certificate of deposit that extends over a five-year time period carries higher interest rates.

In return to the money you lend to the bank, you get interest.

So, to summarize interest rates are higher for long-term debt and lower for short-term debt.

Nevertheless, the yield curve can be inverted. This event is met by general excitement and with concern.

An inverted yield curve results when short-term interest rates are higher than long-term interest rates. Such an event has been caused by the Fed's action of increasing short-term interest, while long-term interest rates have not experienced the corresponding adjustments.

Inverted yield curve is interpreted in several ways. One of them is that investors lack confidence in the short-term prospects of the economy. Another interpretation is that recession is nearing.

The latter interpretation holds truth in some cases, but there are exceptions.

Predicting what is about to happen in economic terms is often marked with a high level of uncertainty. The longer the time period, over which predictions span, the less accurate the predictions are.

In order to fight the negative effects of a potential recession occurrence you should concentrate on diversifying your investment portfolio.

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For knowledge we can highly recommend you subscribe to the The Wall Street Journal.

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