Which of the following statements is true regarding an inverted yield curve? A An inverted yield curve slopes upward B An inverted yield curve suggests long-term yields are greater than short-term yields C An inverted yield curve suggests a recession may be coming D An inverted yield curve suggests that investors think that interest rates will rise in the future
The Correct Answer and Explanation is:
Correct Answer: C An inverted yield curve suggests a recession may be coming
An inverted yield curve is a situation in the bond market where short-term interest rates are higher than long-term interest rates. Normally, longer-term bonds offer higher yields than short-term bonds because of the risks associated with time, such as inflation and uncertainty. When this normal relationship reverses, the yield curve inverts.
Why does an inverted yield curve suggest a recession may be coming? Investors often interpret an inverted yield curve as a signal that the economy is likely to slow down. When investors believe a recession is on the horizon, they expect the central bank (like the Federal Reserve) to lower interest rates in the future to stimulate the economy. As a result, they begin buying long-term bonds, which increases their prices and lowers their yields. At the same time, short-term interest rates remain high or rise due to current monetary policy. This creates an inversion in the curve.
An inverted yield curve has a strong track record of predicting recessions. Historically, every recession in the United States over the past several decades has been preceded by an inverted yield curve, although not every inversion results in a recession.
Let us also examine the other options:
- Option A is incorrect because an inverted yield curve slopes downward, not upward.
- Option B is incorrect because it describes a normal yield curve, not an inverted one.
- Option D is incorrect because an inverted yield curve usually suggests that interest rates will fall in the future, not rise.
In summary, the most accurate statement about an inverted yield curve is that it suggests a recession may be coming, as it reflects investor pessimism about the economy’s future.
