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Advisors - May 23, 2022

Inverted Yield Curve: What It Means and How to Navigate it

At the start of April 2022, the 3-Year Treasury Note yielded the most of any US treasury. The 3-year rate was higher than the 5-year, 10-year, 20-year, and even the interest paid by a 30-Year Treasury Bond, which was yielding 17 basis points less than the 3-Year. In similar fashion, the 10-2 year treasury spread, one of the most closely-followed yield spreads, flipped negative to start the month of April and tripped the alarms of recession worriers.

Chart of US Treasury Yield Curve as of April 1 2022

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While the yield curve is mostly normalizing again as of late May 2022, the fact that some spreads turned negative indicates uncertainty in the markets. Yield curve inversions are regarded by many as warning signs of a recession, as they are relatively rare but have preceded US recessions.

With treasury products ranging from 1-Month T-Bills to 30-Year Bonds, a large number of yield spreads exist. In addition to the 10-2 year yield spread, the 10 year-3 month spread is also a well-followed leading indicator of recessions. In addition, the 10 year-3 month data point represents the relationship between long-term bonds and what’s often considered the risk-free interest rate.

The 10-2 yield spread went negative in late March and early April, while the 10 year-3 month spread has been trending in a more normal direction.

Chart of 10-2 year and 10 year-3 month Treasury Yield Spreads

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So is it worth worrying over this recent yield curve inversion? Is a recession coming? And if so, how soon? Who tends to be the winners and losers of an inverted yield curve?

 

Inverted Yield Curves and Recessions

Under normal conditions, investors receive more yield if they agree to commit their cash for longer time periods, hence why longer-term bonds usually offer higher yields than shorter-term ones. So the fact that an investor on April 1st, 2022 could have locked in a 2.61% effective annual yield with principal paid back in three years, but just 2.44% for 3 decades doesn’t sound quite right, does it?

This is just one example of an inverted yield curve. Much like your favorite (or most hated) theme park roller coaster that twists upside down, an inverted yield curve is when yield spreads flip negative, and shorter-term notes are paying higher effective yields than longer-term bonds. The yield curve is considered “normal” when longer-term bonds yield more than shorter-term ones.

An inverted yield curve occurs when near-term risks increase. Investors demand relatively greater compensation from shorter-term treasuries, and long-term expectations for the economy sour.

There have been six major US recessions, defined by at least 2 consecutive quarters of negative GDP growth, since 1976. Represented by gray panels in the below chart, all six recessions were preceded by the 10-2 spread going negative, and each recession occurred less than two years after the 10-2 spread first inverted.

Chart of 10-2 year Treasury Yield Spread

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The 10 year-3 month spread historically hasn’t given as early of warnings as the 10-2 year, but flipped negative before all 6 recessions as well. The one exception is the 2020 recession, where the 10-3 month spread turned negative almost twice as far in advance of the official recession than the 10-2 did.

Chart of 10-3 month Treasury Yield Spread

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An inverted yield curve doesn’t necessarily mean a recession will happen immediately, nor have yield spreads historically stayed negative for very long. But given that all of the aforementioned recessions occurred in the two years following the 10-2 spread going negative, a recession is something to watch for come…2024? Or perhaps sooner?

 

How Consumers Can Be Affected by Inverted Yield Curves

Consumers seeking short-term loans tend to be worse off amidst an inverted yield curve. Interest rates rise and costs of borrowing go up, leading consumers to either pay higher prices, or defer purchases and investments altogether.

This unfriendly environment tends to sour the consumer’s mood. Though yield curve inversions have happened to precede recessions, decisions made by the consumer can ultimately flip the switch and force the economy into contraction.

For each of the six recessionary periods listed above, and also at the time of a negative 10-2 year or 10 year-3 month spread, the US Consumer Sentiment Index published by the University of Michigan was either declining, below its historical average, or both. The same goes for the US Consumer Price Index, which was either on the rise, above its historical average, or both in all six periods.

As of March 2022’s end, when the 10-2 briefly dipped negative, the Consumer Sentiment Index was trending downward. Currently, the index is at levels similar to those seen in the Great Recession of 2007-2009.

Chart of 10-2 year treasury yield spread, Consumer Sentiment index, and Consumer Price Index

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The 10 year-3 month spread, however, tells a different story about how consumers feel today. The Consumer Sentiment Index is nearing historical lows, but unlike the 10-2 year spread, the 10 year-3 month is growing positively larger. Perhaps the 10 year-3 month is just late to the party, as it’s typically been in the past, or it’s shrugging off the possibility of a recession altogether?

Chart of 10-3 month treasury yield spread, Consumer Sentiment index, and Consumer Price Index

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How Equities Can Be Affected by Inverted Yield Curves

Companies in the business of short-term borrowing and long-term lending, such as banks, have historically underperformed when the yield curve inverts. Borrowing costs increase near-term, and profits get compressed when long-term loans are issued with less attractive rates.

Stocks bearing high dividend yields are also thought to be less attractive when short-term rates spike. Yield-seeking investors may flee equities in favor of shorter-term treasuries since payments can be captured without inheriting company risk.

On the flip-side, companies who issue short-term loans would expect to see a bump in interest payments. The same goes for companies with large amounts of liquid assets. Two of the largest companies on earth, Apple (AAPL) and Berkshire Hathaway (BRK.B), have historically logged large figures on the Cash and Short-Term Investments lines of their respective balance sheets. When short-term rates rise, these companies can expect a greater return on any new short-term investments.

 

How Fixed Income Can Be Affected by Inverted Yield Curves

Inverted yield curves raise short-term US treasury yields closer to those of riskier bond types such as junk bonds, corporate bonds, and also real estate investment trusts (REITs). When the spreads between lower-risk US treasuries and these higher risk, non-Treasury backed securities contract, the US treasuries would be viewed as more attractive.

This chart of the Moody’s Aaa Corporate Bond vs. the 2 Year Treasury and High Yield Junk Bond vs. the 2 Year Treasury shows the narrowing spreads between these usually riskier instruments and short-term treasuries during yield curve inversions.

Chart of Moody's Aaa and US High Yield CCC bonds vs 2 year treasury rate

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A flat or inverted yield curve also brings short-term treasury rates closer to or greater than long-term ones. This presents a situation in which investors could lock in a similar interest rate at a lower duration to maturity. One thing to note: if short-term rates continue rising, like they did around the end of March 2022, then that bond value would likely decrease. But, assuming the investor is willing to accept implied short-term risk and believes the issuer (the US government) won’t default, he or she might have an opportunity to achieve a greater effective yield from their cash.

 

The Bottom Line 

Several different yield spreads have turned negative in 2022, but history has shown that any negative fallout following a yield curve inversion doesn’t come immediately. Investors that take cues from the 10-2 year spread might look to the 10 year-3 month spread as well, as both have preceded all six recessions that have occurred dating back to 1980. Like any other market event, an inverted yield curve causes its own share of winners and losers. Investors who are prepared with a strategy fit to weather near-term events will eventually see the light at the end of the tunnel when the yield curve gets back to normal.

 

How to Stay Ahead of Yield Curve Inversions

As noted above, YCharts has pre-built 10-2 year and 10 year-3 month as well as 30-10 year spread indicators for tracking relationships between short and long-term treasuries. Looking for more than that? YCharts’ custom spreads feature lets you pair any of our 400,000+ indicators together to illustrate any sort of spread that your heart desires.

You can plot the 30-Year/3-Year spread mentioned earlier, or go as wide as the 30-Year/1-Month spread to identify which fixed income instruments are headed for inversion:

Chart of 30-3 treasury spread and 30-1 month spread

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YCharts also contains all Canadian treasury bill and benchmark bond yield indicators. Just as is possible with US treasuries, a Canadian yield curve can be constructed in YCharts as well, featuring durations as short as the Canadian 1-Month Treasury Bill all the way up to the 10-Year Benchmark Bond:

Chart of Canadian Yield Curve as of May 1 2022

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Want to save time in your research? YCharts offers a library of pre-built chart templates, which can be accessed in just a couple of clicks. In Fundamental Charts, select New From Template from the file name dropdown, navigate to Economic Data, choose one of the related yield curve templates, and Voilà! You’ll instantly have a chart of key metrics and their performances over time, such as the 10-2 Treasury Spread vs. S&P 500 or the entire yield curve.

Inverted Yield Curve YCharts GIF

 

Finally, watch our recent episode of What’s Trending on YCharts? here to see which indicators related to the inverted yield curve were most viewed on YCharts:

 

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