The yield curve is something that is often spoken about but rarely followed closely by most investors…unless you are bond trader. However, when news of a yield curve inversion hits the tape, all types of investors – even non-investors take notice. There is much mystery around an inverted yield curve. What does it mean and what are the real implications of it to average investors, to lenders, and most importantly the economy? “What is an inverted yield curve” you ask? An inverted yield curve is an environment in which short term interest rates are higher than long term interest rates. To fully understand what that means, we need to first understand how bonds work.
A very, very quick refresher on bonds
When an investor purchases a bond, he or she is lending money to a borrower, which in this case is a bond issuer. The issuer pays the investor interest during the term of the bond and returns the investor’s principal at maturity. The investor is taking risk by lending out money and is rewarded for taking that risk with interest. There are three high level risks that bond buyers take:
1. Company risk
2. Inflation risk
3. Time risk
Company risk is associated with a borrower’s health and its ability to pay not only the interest but to repay the principal at the end of the term. Inflation risk is the risk that lenders take when locking in a rate for the term of a loan, assuming that inflation will not pick up. For example, if an investor lends out money at 3% for 5 years with inflation at 1%, the investor’s real return is 2%. If inflation picks up to 2% during the term, the investor’s real interest rate will go down to 1%. Time risk, as implied in its name, is the risk associated with the length of the loan commitment. The longer the maturity, the greater the chance of something going wrong with the company or a change in the inflation environment. That is why when an investor buys a longer maturity bond, her or she expects a higher return (or yield) for the risk.
The Yield Curve
The yield curve is a simple plot that displays the yield to maturities of different maturity US Treasury bills, notes, and bonds. On the x-axis going from left to right are maturities that range from 3 months out to 30 years. On the y-axis is the yield to maturity offered by each Treasury issue. Based on what you now know about bonds and maturities, you would expect that a normal yield curve would be upward sloping from left to right. The chart below is the yield curve from 5 years ago. It would be considered normal as the longer maturities provide higher yields.
Inverted Yield Curve
As its name implies an inverted yield curve is a downward sloping curve from left to right. The negative slope is a result of shorter-term yields exceeding longer term ones. What causes the yield curve to invert? When economic conditions are expected to worsen in the future, an active Fed would deploy monetary policy to stimulate the economy. If it is expected that rates in the future will be lower, investors would want to lock in the higher rates that currently exist. Further, the 10-year US Treasury Note is perhaps the most stable global asset from a risk perspective. When times get tough, investors turn to Treasuries as a safe haven investment. As demand for longer maturity bonds increases, prices go up, pushing yields down. Shorter-maturity yields are closely tied to the Federal Reserve’s rate policy, so in an environment where the Fed is raising rates (like today) or holding them constant, shorter-term yields will either move up or remain relatively stable. The result: the front part of the curve remains unchanged or rises while the back end of the curve goes down, which causes the curve to flatten and ultimately slope downward.
What does an inverted yield curve mean?
It is important to recognize that while an inverted yield curve may occur as an economy peaks and heads into a recession, it does not cause a recession. Of course, inversions have implications for certain sectors, particularly in the banking sector which relies on a normal steep yield curve to make money lending on spread, but generally speaking, an inverted yield curve does not have any direct hand in causing a recession. Now that we know that an inverted yield curve is a rare event that can happen when investors are predicting a recession and the Federal Reserve is raising or holding short term rates steady, we can look back and see if inversions in the past have predicted recessions. Below is a chart that plots the historical difference in yield between 2-year notes and 10-year notes with the areas shaded in gray being recessions. You will see that the curve inverted prior to all of the four recessions on this chart. In fact, if you go back further you will find that the inverted yield curve accurately preceded every recession except for 1 in the mid 1960’s. That is why investors should and do take note when the yield curve inverts.
Historical Spread Between 2-year and 10-year Treasury Note Yields
What does this mean for us today?
Leading up to the pandemic, the yield curve had been flattening and, in fact, briefly inverted in the summer of 2019. The economic expansion that followed The Great Recession was already the longest in modern history. Companies were struggling to maintain steady earnings growth and markets were struggling. Inflation was low and unemployment was at 50-year lows. The Tax Cuts and Jobs Act of 2017 gave companies the break that they needed to sustain them for several quarters, but its effects were quickly wearing out by mid-2018. The Fed, therefore decided to step in and cut rates for what it called a “mid-cycle correction.” The cuts had immediate effect. The accommodation shored up markets, made borrowing cheaper, and caused the yield curve to steepen into year-end. It almost seemed as if the US would be able to avoid the long-awaited recession…until COVID struck. The virtual shutdown of the global economy caused even the strongest companies to buckle. Massive job losses ensued, and economic output quickly ground to a halt causing a recession. The Fed responded with an unprecedented monetary stimulus package which included it lowering the key lending rate to 0%. The move caused the front end of the yield curve to go down, ultimately steepening the yield curve. Monetary (provided by the Fed) and fiscal stimulus (provided by Congress) pulled the US out of recession and into a period of aggressive growth. A reopening economy combined with stimulus checks and increased saving gave consumers the confidence to go out and do what they do best: consume. The increased demand began to put upward pressure on prices. That was the birth of inflation, and longer-maturity treasury yields began to climb to compensate bondholders for inflation. The Fed’s keeping rates at 0% caused the yield curve to steepen. Soon came supply chain log jams. Decreased supply with increased demand further pressured inflation higher. Higher long-maturity yields caused the curve to steepen further. As inflation hit 30-year highs it became clear that the Fed needed to pump the brakes and raise rates. Once the Fed made clear that it was preparing to fight inflation with hikes, shorter-maturity yields began to rise. Remember, those yields are closely tied to Fed policy, while longer-maturity yields reflect expected market conditions. If bond traders expected hot growth and inflation to continue, 10-year maturity yields would continue to rise, and they did, but not as quickly as shorter-term 2-year Treasury notes. This caused the yield curve to flatten. At the beginning of 2022 the Fed began to signal its intent to tighten policy even more aggressively. The bond market began to factor in stalled longer-term economic growth and lower long-term inflation. This caused the curve to flatten yet further. Finally, on March 29th, the yield curve between 2-year and 10-year notes briefly turned negative, intraday. The curve inverted.
The following chart below shows the current yield curve versus the yield curve on 12/31/21. You will note how aggressively the 2-year/10-year curve flattened.
Conclusion
An inverted yield curve tells us that investors are expecting future rates to be lower as a result of a weakening economy and lower inflation. Inversions are rare and have pre-dated all except one prior recession. That last inversion occurred in 2019. While it seemed that decisive stimulus from the Fed in 2019 helped avoid a recession, COVID ultimately caused a recession in 2020. Further aggressive stimulus from the Fed has contributed to inflation. Now the Fed has begun an aggressive tightening cycle and the yield curve has briefly inverted, once again. Does this mean that we are headed for a recession? No, it does not, but it does warrant vigilance. Investors must carefully watch the Federal Reserve, the performance of the economy, and most importantly, consumer behavior. Investors must be prepared to act if the investment landscape changes.