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The inverted yield curve is a financial term used to describe an economic situation in which short-term interest rates are higher than long-term interest rates. It specifically refers to a circumstance where the yield on short-term government bonds (for example, two-year treasury bonds) is higher than the yield on long-term government bonds (e.g., ten-year treasury bonds).
Although this inversion of the yield curve is not common, it has historically been a good indicator of economic downturns. This is so that it is clear that there is little faith in the economy's long-term prospects when the yield curve is inverted. When long-term interest rates are lower than short-term rates, it indicates that investors anticipate a slowdown in economic growth in the near future, which will result in lower inflation and longer-term interest rates.
The forecasting ability of the inverted yield curve is what makes it significant. Since 1950, all US recessions have been foreshadowed by inverted yield curves, with the exception of one false positive in the middle of the 1960s. Investors and policymakers receive an early warning signal from the inversion, which normally happens several months to a year before the start of a recession.
