The Inverted Yield Curve: What It Means and How to Navigate It
The 3-Month Treasury Bill’s rate of 5.56% is currently the highest among US treasuries as of August 16, 2023. It was near 0% at the beginning of last year.
The 3-month rate is currently higher than the 3-year by 88 basis points. At the end of May, the 1-Month Treasury Bill eclipsed 6% for the first time ever, and was the first treasury instrument to do so since 2002.
This is a situation known as an inverted yield curve. An inverted yield curve is when shorter-term notes pay higher effective yields than longer-term bonds. The yield curve is considered “normal” when longer-term bonds yield more than shorter-term ones.
How much should you worry about this 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?
What Inverted Yield Curves Mean for Recessions
Generally, investors receive higher returns when they agree to commit their cash for longer time periods. So the fact that an investor today could lock in a 5.52% effective annual yield with principal paid back in one month, but just 4.28% for one decade doesn’t sound quite right, does it?
An inverted yield curve occurs when near-term risks increase. Investors demand greater compensation from shorter-term treasuries when long-term expectations for the economy sour.
At the same time, the technical definition of a recession was met early last year when two consecutive quarters of negative GDP growth were logged between Q1 and Q2 2022. No recession has materialized since.
The 10 year-3 month spread is also a popular recession indicator and represents the relationship between long-term bonds and what’s often considered the risk-free interest rate. In late October, the 10 year-3 month spread turned negative for the first time since February 2020. It is now almost twice as negative as the 10-2 year spread.
There have been six major US recessions since 1976, per the National Bureau of Economic Research’s definition (NBER). Represented by gray panels in the below chart, all six recessions were preceded by an inverted 10-2 spread lasting longer than two months, and each recession (other than the 2020 pandemic-induced one) occurred less than two years after the 10-2 spread first inverted.
Historically, the 10 year-3 month spread hasn’t given warnings as early as the 10-2 year, but flipped negative before all 6 recessions as well. The one exception is 2020, where the 10 year-3 month spread turned negative almost twice as far in advance of the recession than the 10-2 year did.
An inverted yield curve doesn’t necessarily mean a recession will happen at the snap of a finger. Nor have yield spreads historically stayed negative for very long. In fact, recessions don’t typically occur while the yield curve is inverted.
Instead, what often happens is that the yield curve starts to gradually “un-invert” shortly before a recession. This reversal is usually triggered by either rate cuts or the imminent possibility of them, leading to a decrease in short-term bond yields.
During the 2007-2009 recession, rate cuts or expected rate cuts triggered a surge in longer-term bond prices – illustrated by the iShares 10-20 Year Treasury Bond ETF (TLH) – leading to a decline in yields. Consequently, the yield curve normalized during this “bull steepening” event.
Recently, the price of TLH has been on a downward trend, accompanied by a notable surge in 10-year yields. However, the increase in 2-year yields has been relatively minor. This “bear steepening” has resulted in a less inverted yield curve, albeit in an unconventional manner. These trends suggest that investors are becoming more optimistic about the economy and are lowering their expectations of future interest-rate cuts.
Analysts believe the yield curve could remain inverted longer than usual due to the large yield gap and strong economy. The conclusion of the inversion will reveal whether it is caused by declining interest rates or new bets on the economy’s strength.
Despite recent economic resilience, recessions have historically occurred within two years of a negative 10-2 spread. This, combined with achieving a technical recession by way of two consecutive quarters of negative GDP growth last year, explains the jump in near-term recession probability.
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 tend to precede recessions, decisions made by consumers 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 an inverted 10-2 year or 10 year-3 month spread, the University of Michigan’s US Consumer Sentiment Index 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.
The Consumer Sentiment Index hit an all-time low of 50 last June right as the 10-2 year spread turned negative and inflation peaked at 9%. The index is currently around the same level as it was at the end of the Great Recession of 2007-2009.
Interestingly, the 10 year-3 month spread moved in the opposite direction of consumer sentiment last year. As the Consumer Sentiment Index plummeted to historical lows, the 10 year-3 month spread widened. It seems the 10 year-3 month spread caught up to the reality of depressed consumer sentiment and the highest CPI in four decades.
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.
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 are seen as more attractive.
When a flat or inverted yield curve lifts 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, 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.
How to Stay Ahead of Yield Curve Inversions
As noted above, YCharts has pre-built 10-2 year, 10 year-3 month, and 30-10 year spread indicators for tracking relationships between short and long-term treasuries. Looking to dive deeper? 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:
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.
The Bottom Line
The yield curve has been inverted since July 2022, but history has shown that any economic fallout following a yield curve inversion doesn’t happen 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.
Connect with YCharts
To get in touch, contact YCharts via email at firstname.lastname@example.org or by phone at (866) 965-7552
Interested in adding YCharts to your technology stack? Sign up for a 7-Day Free Trial.