The Yield Curve

FORECASTS & TRENDS E-LETTER
by Spencer Wright
June 18, 2024

The Yield Curve

IN THIS ISSUE:

1. What is “The Yield Curve”?

2. What Does Yield Curve Inversion Mean and What Causes it?

3. Is an Un-Inverting Yield Curve a Reliable Predictor of Recession?

4. Where is the Fed in All This?

5. Final Thoughts

What is “The Yield Curve”?

For context, a yield curve is a graphical representation of the relationship between interest rates and bond yields of differing maturities. It illustrates the yield an investor can expect to earn on their money for a given period of time. The graph displays a bond’s yield on the vertical axis and the time to maturity across the horizontal axis.

Currently when you hear or read “The Yield Curve” it is referencing the relationship between the 10-year and two-year treasuries. Currently the relationship is inverted. That means that the yield on the 10-year instrument is less than the yield on the two-year instrument. This is not the “normal” relationship but is by no means unusual.

The following infographic illustrates the various states of a yield curve.

Chart showing example of yield curves

What Does Yield Curve Inversion Mean and What Causes it?

What causes an inverted yield curve?

An inverted yield curve occurs when short-term interest rates exceed long-term interest rates. There are several factors, some of which you may be unaware, that can cause an inverted yield curve.

Investor Sentiment: When investors become risk-averse and expect a recession, they shift their money from short-term bonds to longer-term bonds, driving up the prices of long-term bonds and lowering their yields. This causes the yield curve to “invert.”

Central Bank Intervention: Central banks, such as the Federal Reserve, can influence the yield curve by raising short-term interest rates. If they raise short-term rates quickly, it can cause the yield curve to invert. As you know, this is our current environment.

Economic Slowdown: An economic slowdown or recession can cause investors to seek safer investments, such as longer-term bonds, which drive up their prices and lower their yields, inverting the yield curve.

Inflation Expectations: When inflation expectations decline, investors may demand lower yields on long-term bonds, causing the yield curve to invert.

Supply and Demand Imbalance: An imbalance in the supply and demand for bonds can cause the yield curve to invert. For example, if there is a surge in demand for short-term bonds, their prices may rise, causing their yields to fall and the yield curve to invert.

Yield Curve Flattening: A flattening of the yield curve, where the difference between short-term and long-term yields narrows, can also cause the yield curve to invert.

As you can imagine, these factors can interact with each other and with other market forces to cause an inverted yield curve. The pressures of the current environment consist of higher short-term interest rates as well as the threat of an economic slowdown, commonly known as recession.

Eventually, an inverted yield curve will un-invert. In the case of the 10-year and two-year instruments, that has historically signaled a coming recession.

Is an Un-Inverting Yield Curve a Reliable Predictor of Recession?

History suggests that inverted yield curves are a reliable predictor for economic weakness. Since WWII, each recession has been preceded by a yield curve inversion. In some cases, the yield curve has inverted without a near-term economic recession. Recessions have tended to lag yield curve inversions by anywhere from six to 18 months.

Here is a chart of the 10-year / 2-year AND 10-year / 3-month inversions from 1980 to 2020.

Chart showing yield curve inversions since 1980

Economic analyst Daniel Schonberger writes, “This time, the 10-year vs. 2-year treasury inverted in April 2022 and the 10-year vs. 3-month treasury inverted in October 2022. And this is leading to 26 and 20 months respectively since the yield curve inverted. When looking at the data above it never took that long between the first inversion and the actual beginning of a recession. However, before the Great Financial Crisis both metrics inverted 23 months before the start of the recession which is still like the situation right now.”

However, in these past cases, the yield curve un-inverts just before the recession begins. This is generally due to the Fed cutting rates in response to some type of economic stress. So, it is the un-inversion that is the signal of the recession to come. The current 10-year / 2-year inversion is the longest recorded. Does that have any significance? That is unknown but a very good question.

Where is the Fed in All This?

The Fed has quite a large role in fluctuating yield curves and the resultant outcomes. The 10/2 yield curve most recently inverted after the Fed raised interest rates at the fastest pace in over 40 years to quash the worst inflation the US has seen since the 1970s. To date this effort has been successful, although at a slower pace than the Fed would have liked.

The Fed is trying to engineer a “soft landing” for the economy, meaning economic slowdown that does not end in a recession. History tells us that is highly unlikely. The fact that the Fed has been forced to maintain its “higher for longer” stance only increases the likelihood of a recessionary outcome.

Final Thoughts

Remember that the stock market is not the economy. Currently we are “through the looking glass” in that bad news for the economy is good news for the stock market. As the economy weakens, the Fed will eventually reduce rates, which is positive for the market. BUT, the Fed is doing this in response to a weakening economy.

Maybe the Fed will be able to land softly, and there won’t be a recession once the yield curve un-inverts. But it isn’t likely. The trouble with a recession – two consecutive quarters of negative growth – is you can only view it in hindsight.

Thanks for reading,