The Inverted Yield Curve: Economic Alarm Signal

The yield curve plots Government of Canada bond yields against maturity, from 3 months to 30 years. Under normal conditions, it slopes upward: investors demand higher yields for lending money over longer periods, compensating for increased inflation risk and uncertainty. When this relationship inverts — short-term bonds offering higher yields than long-term — markets signal an anticipation of economic difficulties. This phenomenon is one of the most reliable recession indicators in financial economics.

The Inversion Mechanism

Inversion typically occurs in two stages. First, the central bank raises the policy rate to fight inflation, pushing short-term yields higher. Second, investors anticipating that these hikes will cause an economic slowdown flock to long-term bonds (safe havens), driving down their yields through increased demand. The most watched spread is between the 2-year and 10-year bond (2-10 year spread). When this gap turns negative, the curve is said to be inverted. In Canada, the 3-month/10-year spread is also closely monitored.

Consequences for Mortgage Rates

Inversion creates significant anomalies in the mortgage rate structure. In normal times, the 5-year fixed rate is higher than the 3-year fixed, and variable rates are generally lower than fixed. During inversion, these relationships can completely reverse. The 5-year fixed can drop below the 3-year fixed, and variable rates (following the elevated prime rate due to a high policy rate) can exceed fixed rates. This situation presents both risks and opportunities for borrowers.

Implications for Quebec Borrowers

• Long-term fixed rates (5 years) potentially more advantageous than short terms (1-3 years), an anomaly favouring locking in a lower rate for a longer period
• Variable rates potentially higher than fixed rates, making fixed more attractive short-term but variable potentially winning if anticipated cuts materialize
• Opportunity to lock in a low 5-year fixed rate if the borrower believes a recession is approaching and rates will fall after the term expires
• If recession materializes, variable rates will decline with future policy rate cuts, rewarding borrowers who accepted the higher short-term variable cost
• The stress test (B-20) uses the contractual rate + 2% or 5.25%, which may further penalize variable-rate borrowers during inversion when the variable rate is high

Broker Strategies During Inversion

Assessing each client's risk tolerance becomes crucial during inversion. For a cautious client with a tight budget, a 5-year fixed rate offers security and, during inversion, a potentially lower rate than shorter terms. For a risk-tolerant client with financial buffer, a variable rate could prove winning if market-anticipated rate cuts materialize, though initial payments will be higher. The broker should present quantified scenarios comparing total cost under different rate trajectory assumptions: maintained, gradual decline, or rapid decline.

Historical Analysis in Canada

Canadian historical data shows inversion has been a reliable, though imperfect, recession predictor. The 1990-1991 recession was preceded by inversion in 1989. The brief 2001 recession (tied to the tech bubble burst) was preceded by inversion in 2000. The 2008-2009 financial crisis was signalled by inversion in 2006-2007. More recently, the deep 2022-2023 inversion coincided with significant economic slowdown, though technical recession was narrowly avoided. For brokers, this data underscores the importance of considering the yield curve as one indicator among others, combining it with employment, GDP, and CMHC indicators.

Key Takeaways for Brokers

The inverted yield curve is a powerful but not infallible signal. Brokers should use it as one tool among many in their market analysis. During inversion, client communication becomes even more important: explain why rates seem 'upside down,' present strategic options, and document recommendations. The Bank of Canada website publishes daily bond yields for all maturities, allowing brokers to plot the curve and quickly identify inversions.