Understanding the inverse Yield Curve: what drives its movements and what it can

tell us about the near future.

This article is a translated and commented abstract from a previous author’s analysis on the yield curve-
based monetary policies. (Olivieri F.M., 2022)

An inverse yield curve is a type of interest rate environment in which long-term debt instruments have a
lower yield than short-term debt instruments of the same credit quality. This phenomenon is unusual
because, in a normal yield curve, long-term debt instruments tend to have higher yields than short-term debt
instruments to compensate investors for tying up their money for a longer period of time.

The yield curve is typically plotted on a graph with the yield on the vertical axis and the maturity of the debt
on the horizontal axis. Under normal circumstances, the curve slopes upwards from left to right, reflecting
the higher yields on longer-term debt. An inverse yield curve, on the other hand, slopes downward from left
to right, indicating that longer-term debt has a lower yield than shorter-term debt.

An inverse yield curve can occur for a variety of reasons, but it is often seen as a sign of an impending
recession. When investors are uncertain about the future and believe that economic conditions will
deteriorate, they may demand a higher yield on shorter-term debt to compensate for the increased risk. This
can cause the yield curve to invert, as shorter-term rates rise while longer-term rates fall.

Historically, an inverted yield curve has been a reliable indicator of a recession. In the past, every recession
in the United States has been preceded by an inverted yield curve. However, it is important to note that not
all inverted yield curves lead to a recession, and not all recessions are preceded by an inverted yield curve.
(source Federal Reserve Bank of St. Louis (07/01/2023) . The term spread ability to anticipate a recession:
the grey areas represent recessions and the blue line is the difference between the 10 years us bond yield and
the 2 years one)

In the current economic environment, the yield curve has been a topic of much discussion and speculation.
The yield curve has been fairly flat in recent years, and there have been concerns that it could potentially
invert. Some analysts believe that an inverted yield curve could be a warning sign of a recession in the near
future, while others argue that the relationship between the yield curve and the economy has changed in
recent years and may not be as reliable a predictor as it has been in the past.

Regardless of the specific circumstances, an inverted yield curve is generally seen as a cause for concern
and is something that investors and market participants should be aware of. It is a good idea to stay informed
about the yield curve and other economic indicators, as they can provide valuable insights into the state of
the economy and the potential risks and opportunities that may be on the horizon

Nowadays it is of great interest to understand why the yield curve may be downward sloping since we are
currently witnessing the most inverted yield curve ever and never as nowadays the most remarkable
financial newspapers are talking about the predictive power of this instrument and their increasing fear of a
possibly near recession.

However, the mechanisms that drive the curve movements are not always easy to understand and known by
the average investor. Thereby, I believe that it is useful to have it clarified by a simple model.

In the following article I will develop a theoretical model which may describe the term spread (i.e. the
difference between the short-term bond yield and the long-term bond yield).
Let’s start from the basics.

Recalling to the reader's mind Fisher's equation:

𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒

We can easily understand that, if this equation is valid in bonds with short maturity, for it to be valid for
long-maturity bonds as well, adjustments have to be made.
Let us, therefore, consider the fact that there is uncertainty about the level of inflation that will be realized
when the bond matures and about the future real interest rate.
We, therefore, observe long-term bonds:

𝑙𝑜𝑛𝑔 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒

= 𝐸𝑋𝑃𝐸𝐶𝑇𝐸𝐷 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 + 𝐸𝑋𝑃𝐸𝐶𝑇𝐸𝐷 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒

The spread between long and short will therefore be:

𝑖!" − 𝑖#" = (𝐸𝑋𝑃𝐸𝐶𝑇𝐸𝐷 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡) + (𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 − 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛)

Which we can rewrite as:

𝑖!" − 𝑖#" = ∆𝑟 + ∆𝑖𝑛𝑓

We are therefore left with an understanding of what are the main causes of conditioning the term spread
between long and short-term maturity.

However, our analysis can dig deeper: Asking what are the determinants of expected real interest rate and
expected inflation is inevitable.

By following the analysis proposed by Philip R. Lane (2019) (member of the Executive Board of the ECB)
in his speech "Determinants of the real interest rate" to the National Treasury Management Agency we
understand that the three fundamental determinants of the level of the real interest rate are: the potential
growth rate of the economy, demographic trends, and developments in divergences in yields between risky
and safe assets.
Regarding the former, it is quite clear that a growing economy needs high real interest rates to stimulate a
higher level of savings to support the investments necessary for growth. Therefore, a scenario of optimism
in the markets concerning the future of the economy cannot but reflect positively on the expected real
interest rate. This growth can also be determined by technological development.

Considering demographic trends, we can state that, as it is well known, an increase in the working
population has a positive impact on economic growth and thus, as mentioned above, on the expected real
interest rate.
Regarding the third determinant, Lane observes that the movement of capital from risky to risk-free assets,
such as government bonds, reduces the real interest rate.

Turning instead to analyzing the determinants of expected inflation, we can refer to the quantity theory of
money (QTM), through which the classical dichotomy theory is unraveled.
In the long run, in fact, according to this theory, nominal variables are only influenced by other nominal
variables and do not influence real variables and vice versa. In the short run a monetary expansion, on the
other hand, can affect real variables given the stickiness of prices to adjust to the amount of money in
circulation. In addition, the presence of possible supply shocks should be considered for the short and
medium term.

Given these premises, we can proceed to construct a small, very simplified model which, however, helps us
to determine the term spread between long and short-maturity bonds:

With regard to ∆r, we observe that:

$%&
∆𝑟 = 𝑓(𝑔$%& − 𝑔; 𝑟'(#) )

Where 𝑔$%& and g are respectively the expected and current growth of the economy and are positively
$%&
correlated with ∆r. On the other hand 𝑟'(#) , which represents the expected average interest rate on risky
assets should be negatively correlated following Lane's assertion and assuming that the capital divested from
the risky asset spills over at least in part into a safe asset.

Regarding ∆inf, we observe that:

∆𝑖𝑛𝑓 = 𝑓(𝑀; 𝑆 #*+,) )

Where M represents the money supply and, considering a reality with sticky prices, has a greater positive
impact on expected inflation than on actual inflation, hence, is positively correlated with ∆inf.
Whereas Sshock , which represents a supply shock, is of uncertain sign depending on the duration and impact
of the shock on the market and on the expectations of traders as to when it will return to normal conditions.

We can therefore conclude by saying that 𝑖!" − 𝑖#" , and hence the slope of the curve, is positively correlated
with the difference between current and expected growth (𝑔$%& − 𝑔) and money supply (M); it is
$%&
negatively correlated with the expected average interest rate on risky securities (𝑟'(#) ) and is affected by
supply shocks (𝑆 #*+,) ). with uncertain intensity and sign.

The model can be written as:

$%&
𝑖!" − 𝑖#" = 𝑎(𝑔$%& − 𝑔) + 𝑏𝑀 − 𝑐(𝑟'(#) ) ± 𝑑(𝑆 #*+,) )

This very simplified model (deliberately not taking into account some essential aspects that I preferred to
introduce later in the exposition of the subject) helps us to understand only in part the dynamics that
condition the positioning and slope of the Yield curve but I believe it can be useful to the reader to begin to
understand the mechanisms behind this fascinating and complex instrument.
We can now try to apply these considerations to the current economic situation and see if the model shows
itself accurate.

In the following chart we can see how much the yield curve is now inverted. Analysts typically consider the
2-10 years and 5-30 years yields’ spread (both negative).

(source: Refinitiv workspace. 8/01/2023 yield curve)

We can definitely assess, after all the previous analysis. that this kind of slope shows anything but a
flourishing future for the economy. The term spread has never been that negative and the american labor
market data (U.S. non-farm payrolls) are showing us a slower than expected reaction of the
unemployment increase to the FED’s hawkish monetary policy

(source: Refinitiv workspace. Expected (blue) vs Actual (yellow) increase of Non-farm workers in USA)
 (source: Refinitiv workspace. Expected vs actual unemployment rate in USA)

A straightforward consideration that we can make looking at these data is that the inflation may be far from
being under the FED’s control and that a lower bps rate increase in the near future should be weighted with
a lower probability. Hence, looking at the expectation components of the yield curve model previously
explained we can easily assess that

$%&
𝑖!" − 𝑖#" = 𝑎(𝑔$%& − 𝑔) + 𝑏𝑀 − 𝑐(𝑟'(#) ) ± 𝑑(𝑆 #ℎ+,) )

The expected growth rate is lower than the current one considering the current attempt to slow down the
economic growth to dominate the inflation (𝑖. 𝑒. (𝑔$%& − 𝑔) should be negative).

Unsurprisingly the investments in risky assets have decreased given the higher probability of default and
$%&
uncertainty in the market and so the high yield assets’ rate(𝑟'(#) ) have consequently increased.

The FED restrictive monetary policy is reducing the monetary base hence M is negative.
Indeed, even though the markets are starting to believe that a FED pivot to a dovish policy is soon to come
after the CPI data had shown a decline, we have to look at the FOMC economic projections to really
understand the consensus among the FED economists and try to forecast their intentions.


(FOMC Projections materials, 14 december 2022)

In the table above we can see that the median projection for the 2023 fed funds rate which is supported by
10 out of 19 FOMC participants shows a clear intention of the FED to keep increasing the rates.
To support this interpretation we can observe the projection of the core PCE (core inflation) that still expects
3.5% of inflation at the end of 2023. a 0.4% higher than the September projection.
These projections push me to expect a heavy weight of a negative “M” in the model observed above.
The fact that the market seems not to give this interpretation may lead, in the case of an unexpected hawkish
statement or hike by the Fed, to a curve even steeper than the current one.

We will see in the next few months whether the markets are too optimistic or the Fed will lower its
projections.

One thing is sure, Powell made it quite clear that the FED will be “keeping at it” (as the former FED
chairman Paul Volker would teach us) until the inflation will be completely under control: “Prudent risk
management suggests the risks of doing too little are much higher than doing too much” . (Transcript of
Chair Powell’s Press Conference November 2, 2022)

By Filippo Mistral Olivieri,

ESCP Finance Society, Markets and Asset management Associate
References
● Olivieri F.M. (2022): Yield curve: Indicatore di recessione e strumento di politica monetaria, Luiss
Guido Carli
● Lane P. L. (2019): Determinants of the real interest rate , in speech at the National treasury
Management Agency,
Dublin.<https://www.ecb.europa.eu/press/key/date/2019/html/ecb.sp191128_1~de8e7283e6.en.html
>
● Schumpeter, J.A. (1942): Capitalism, Socialism and Democracy. Vol. 36, Harper & Row, New York
● Federal Reserve Bank of St. Louis (07/01/2023), 10-Year Treasury Constant Maturity Minus 2-Year
Treasury Constant Maturity [T10Y2Y], retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/T10Y2Y, January 7, 2023.
● Refinitiv workspace data elaborations 08/01/2023
● Transcript of Chair Powell’s Press Conference November 2, 2022
● FOMC Projections materials, 14 december 2022:
<https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20221214.htm>