June 2, 2023 | 5-minute read (922 words)
At the end of 2022, the yield curve became inverted, raising recession fears in the U.S. It is a phenomenon in the bond market in which short-term yields move higher than long-term yields and has historically preceded recessions in the U.S.
Read on for a quick primer on yield curve inversion, and what it means for startups, investors and the economy as a whole.
Decoding the yield curve inversion
The yield curve represents the relationship between interest rates and the maturity periods of a series of fixed-income securities, like government bonds. You may have also heard the yield curve referred to as the term structure of interest rates.
In stable economic times, the yield curve slopes upwards. That means the longer the maturation period of a bond, the greater the interest rate that bond offers the investor. In other words, because these investors are taking on a little more risk by investing in a longer-term bond, they will receive a higher reward when the bond reaches maturity.
Every now and then, that yield curve becomes inverted. Instead of longer-term bonds being worth more than short-term bonds, the yield curve turns downward, and investors can earn more for short-term treasuries than long ones.
A yield curve inversion has predicted every recession since 1969
When the yield curve reached its deepest inversion since 1981 in March 2023, investors and economists took notice. An upwardly trending yield curve typically signals strong economic activity, national growth, and available capital for businesses and investors. But an inverted yield curve signals a downturn is around the corner.
The whole yield curve doesn’t need to be inverted to suggest turbulent times are ahead. Investors specifically watch two yield spreads — the difference between the three-month Treasury bills and 10-year notes yield, and the difference between the two-year and 10-year notes spread. If either (or both) of these spreads turns negative, a recession may be coming.
In July 2022, the two-year Treasury yield passed the 10-year yield. And as short-term yield growth accelerated in 2023, that spread stretched wider and wider — until it reached an inversion not seen since the early 1980s. The last time the yield spread was this negative, the economy plunged into the worst decline since the Great Depression. But the exact impact and duration of recessions is difficult to predict.
How does a yield curve inversion indicate declining economic activity?
A yield curve inversion is considered a potential predictor of economic decline because as inflation and high interest rates heat up the economy (increasing the curve), the Federal Reserve steps in to cool it back off (inverting the curve). Their tightening monetary policies, like raising interest rates, tend to push down that long-term yield rate, inverting the curve and slowing down economic growth.
This single indicator has been one of the most reliable predictors of economic recession because it occurs as a result of growth-slowing policies or as the economy naturally restricts. It suggests investors believe the future will be less profitable than the present — and that a recession is likely on the way.
How do the yield curve inversion impact startups, small businesses and investors?
There are a few ways the yield curve can impact you. One is that inverted yield curves often lead to tightening lending standards. When a recession is looming, lenders tend to become more cautious about extending loans. If they expect your startup or small business may not have a strong chance of long-term survival, especially if you’re launching in an uncertain economy, they may be hesitant to offer you capital — or charge a steeper interest rate for it.
Another way the inverted yield curve impacts the economy is by damaging investor confidence. In an uncertain economy, investors become cautious about buying stocks and less stable investments. That can make it more difficult to raise funds through equity financing, venture capital and angel investing.
A third way the yield curve inversion impacts the economy is by slowing consumer spending. When everyday buyers hear news of recessionary indicators and economic volatility, they tend to pull back on purchases like luxury goods, big-ticket items like cars, and real estate. They may even shift their buying habits, shopping at lower-price stores or reducing their entertainment purchases. This can affect the sales and growth of direct-to-consumer companies that are sensitive to demand changes.
How should your small business respond to the yield curve inversion?
Small businesses should maintain their financial resilience in every season, especially when a potential economic downturn is on the horizon. Build up your cash reserves, carefully monitor your cash flow, and focus on effective and efficient capital management. A robust financial position now can help your startup weather the market to come.
Another way to protect your startup from a shaky economy is to diversify your revenue streams. If your bottom line relies on one single target audience, or a key product, your company may be carrying too much risk. Look for ways to expand your customer base, enter new markets, or offer additional products and services that are more insulated from market fluctuations. By proactively protecting your company from a downturn, you can mitigate the impact of changing spending patterns.
The inverted yield curve is a cause for caution, not a concern
While this economic uncertainty may present new obstacles, it’s nothing a healthy company can’t overcome. Remember, economic cycles are a normal part of the business environment. And with a bit of strategic planning and forethought, you can continue to thrive through every shift.