Although risk premiums and investors’ conventional preference for the liquidity of short-term bonds has tended to keep the yield curve positive, situations do occur where short-term yields exceed long-term yields. In these cases, the yield curve is described as negative or inverted — sloping downward from the left as maturities increase.
Negative yield curves may emerge when the market anticipates a deteriorating economic situation accompanied by falling interest rates. Investors who expect an economic slowdown tend to lock in long-term bond investments at their current rates, reducing the yield, and avoid short-term bonds in the expectation that short-term rates will fall. This reduced demand increases the short-term yield. Additionally, since a slowing economy often results in a decrease in inflation, existing long-term bonds become more attractive.
Another possible explanation for an inverted curve may be that while the Federal Reserve’s Open Market Committee can exert pressure on short-term rates, it has no direct control over long-term rates. If a rise in long-term rates doesn’t follow an increase in short-term ones, the normal curve will be reversed.
Flat yield curves
In certain cases, there is little or no difference between the yields on short-term and long-term bonds — a situation known as a flat yield curve. A flat yield curve may reflect widespread uncertainty about the future of interest rates and the economy as a whole. Or an extended period when the curve is flat may be the result of shifts in investor attitudes.
When negative is normal
Although it’s common to refer to positive yield curves as normal, this was not always the case in the past. During the 19th and early 20th centuries, prolonged deflation in the U.S. economy led to a situation where negative yield curves were the norm, reflecting the expectation that the value of cash would increase in the future.
In certain cases, there is little or no difference between the yields on short-term and long-term bonds — a situation known as a flat yield curve. A flat yield curve may reflect widespread uncertainty about the future of interest rates and the economy as a whole. Or an extended period when the curve is flat may be the result of shifts in investor attitudes.
