Definition: An inverted yield curve is when short-term Treasury note yields are higher than long-term Treasury bond yields. This means that investors prefer to purchase 10-year Treasury bonds, at a lower yield, than 1-year Treasury bonds.
These investors believe they will make more by holding onto the longer-term bond than if they kept buying and reinvesting in short-term bonds which will return much less in the near future.
This is illogical. Typically, the yields on long-term bonds are higher than short-term bonds because investors want a better return for tying up their money for a longer time. However, if investors believe that the economy will be slowing over the next couple of years, and then speeding up again in 10-20 years, they will be content to tie up their money until then.
For this reason, an inverted yield curve usually means the economy is headed for a recession, as it did before the recessions of 2000, 1991, and 1981. However, if long term yields are low, as they are now, then many economists believe there is enough liquidity in the economy to prevent a recession.
Examples: Foreign demand for U.S. Treasury Bonds have created an inverted yield curve.
