I recently saw a video that tried to explain the reason the yield curve inverts, but I think it missed the point. After reviewing some literature, I've found the following reasons. Whether you think I am on target or off, I would appreciate your feedback.
Importance of Inverse Yield Curves
Inverse yield curves have preceded the last seven recessions in the U.S. Each inverse occured roughly 12 months ahead of the recession. The graph shown in the link below charts the spread between 10-year Treasury bonds and 3-month T-bills. The shaded areas are recessionary periods. (I tried to include the graph here, but I wasn't able to.)
Source: New York Federal Reserve (http://www.ny.frb.org/research/capital_markets/Prob_Rec.pdf)
How the Yield Curve Inverts â Simple Answer
First, a yield curve inversion results from a preference for short-term interest rates. Because short-term rates are normally lower than long-term rates, borrowers prefer to borrow short. So, instead of getting a five year loan at 10% interest, a business prefers five consecutive one-year loans at 7%. On the other hand, lenders arbitrage by borrowing money at short term rates and loaning it at long-term rates. This high demand for short-term loans by borrowers and lenders pushes up short-term interest rates.
Second, towards the end of a period of economic expansion, loans are more difficult to obtain because most available money has been loaned out. With less to loan, lenders prefer making shorter loans, which also raises short-term interest rates.
Third, after periods of expansion, businesses and consumers become more uncertain about the future. Belief that there may be a downturn sooner, rather than later, hence more risk in the near term, pushes short-term rate up, as well.
These three factors combine to push short-term rates higher than long-term rates. This is a signal of financial distress. And, as the graph at the above link shows, it has been a reliable signal that an economic downturn is likely within the next 12-months.