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The yield curve is a graph that plots the yields of bonds that have the same credit quality but across different maturities.
The yield curve can take three shapes:
- Normal Yield Curve: Upward-sloping, indicating economic growth.
- Inverted Yield Curve: Downward-sloping, indicating a potential recession.
- Flat Yield Curve: Indicates uncertainty in the economy.
A normal yield curve typically slopes upward. This means that longer term or longer dated bonds offer investors higher yields due to the increased risks of longer time horizons, such as inflation and economic uncertainty.
Another way to describe this is that this yield curve happens because investors demand a higher premium or yield to tie up their money for a longer time.
This is an example of a normal yield curve that shows the maturities and yields of different U.S. Treasury bonds. The specific Treasury securities shown on this yield curve are the:
- 3, 6, and 12-month Treasury Bills,
- the 2, 3, 5, 7, and 10-year Treasury Notes,
- and the 30-year Treasury Bond.
We also see that the yield increases as the maturity lengthens. The 3-month Treasury bill yields 0.25%, the 5-year bond yields 1.00%, the 10-year bond yields 2.20%, and the 30-year bond yields 3.50%.
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The upward slope of the yield curve generally shows investors have confidence in economic growth. When the economy grows, demand for credit grows, leading to higher interest rates for longer-term loans.
However, if the yield curve flattens or inverts (where short-term rates exceed long-term rates), it can signal a slowdown in the economy or even a potential recession.
Inverted Yield Curve
With an inverted yield curve, short-term interest rates are higher than long-term rates. Here are some periods of yield curve inversions that have occurred in the past:
- 1990s: The yield curve inverted before the 1990 recession, leading to a significant economic slowdown.
- 2000: An inversion preceded the dot-com bubble burst and subsequent recession.
- Early 2020: The COVID-19 pandemic triggered a flight to quality and briefly inverted the yield curve as investors sought safe assets.
- 2006 to 2007: The yield curve inverted before the Great Recession, which was more severe than expected.
During times of uncertainty, investors often seek the safety of long-term government bonds, which drives their yields down. And when short-term rates remain high, this “flight to quality” can cause the yield curve to invert.
Recession Indicator
Historically, yield curve inversions have been strong indicators of an upcoming recession. In 2022, we saw another yield curve inversion when the yield on the 2-year Treasury surpassed that of the 10-year Treasury.
This shift was influenced by the Federal Reserve’s aggressive interest rate hikes as they tried to fight inflation.
When investors anticipate these rate hikes will eventually slow economic activity, they often expect future rate cuts. And this expectation can lead to a drop in long-term bond yields, which further adds to the yield curve inversion.
Data has shown that yield curve inversions typically precede recessions by around 12 to 13 months. For example:
The yield most recently inverted last in October 2022, with a spread of 1.4% between the 3-month and 10-year Treasury yields. That means if you bought a 3-month Treasury Bill, you’d receive a 1.4% higher yield than a 10-year Treasury Bond.
Yield curve getting close to un-inverting
Recently, the yield curve has been flattening and is now on the verge of un-inverting. As of August 29, 2024, thespread between the 10-year Treasury Constant Maturity and the 2-year Treasury Constant Maturity stands at 0.00%.
This yield curve un-inverting can indicate shifts in economic conditions and market expectations. Some potential reasons for the yield curve un-inverting are:
- Easing Inflation: Stabilizing inflation rates can boost investor confidence.
- Market Optimism: Positive economic indicators such as job growth and increased consumer spending can improve investor outlook.
- Federal Reserve Policy Changes: Adjustments in Fed interest rates can influence the yield curve’s shape.
An un-inverting yield curve can mean investors expect stronger economic growth and rising inflation. When long term rates start going up, it can send a signal to investors that the economy is about to recover and that inflation may increase.
For investors, rising long term yields typically lead to falling bond prices. This affects fixed income portfolios where higher yields tend to make bonds more appealing than stocks.
Some scenarios look like this:
- An un-inverted yield curve could support rising stock prices due to increased investor confidence. As confidence improves, investors might shift their portfolios from bonds to riskier assets like stocks.
- Long term bond yields rise as investors seek greater returns, while short-term yields may stabilize.
- For savers and retirees, higher yields make bonds more attractive relative to stocks.
- The yield curve un-inversion can affect currency valuations such as the U.S. dollar.
Final Thoughts
When the yield curve un-inverts, it can mean that the worst of the economic slowdown is over, or at least that the market expects it to be.
As of now, the markets are expecting a 25 basis point cut on September 18. The Fed will likely decide to cut rates that align with these expectations.
But it’s good to keep in mind that historical data has shown that substantial rate cuts may not always give us positive outcomes for the stock market or the broader economy.
