- When coupon payments on shorter term Treasury bonds exceed the interest paid on longer term bonds, the result is an inverted yield curve.
- Some market observers consider a yield curve inversion a harbinger of economic recession.
- At a minimum, it raises the possibility that corporations will be less likely to borrow in order to invest in new projects.
Investors look for indicators that might offer insight into future economic trends. One potential signal that some consider a telltale sign is an “inverted yield curve,” when interest paid on shorter term U.S. government-issued bonds exceeds the interest on longer term bonds. While it may sound like an arcane event, an inversion of the yield curve can suggest significant implications. With recent headlines highlighting an “inverted yield curve,” is this unusual trend in the bond market a harbinger of economic recession?
What is an inverted yield curve?
The concept of the yield curve starts with bonds of different maturities and is often based on yields of U.S. Treasury securities. These are bonds of equal credit quality (all backed by the full faith and credit of the U.S. government) but with different maturities.
A simple way to view the yield curve is to look at current interest rates, or yields, paid by U.S. Treasury securities with maturities of three months, two years, five years, 10 years and 30 years. Investors typically expect to be rewarded with higher yields for investing their money for longer periods of time. This is referred to as a normal yield curve, one where yields rise along the curve as maturities are extended. The chart below depicts a normal yield curve among these five U.S. Treasury securities, which is where things stood at the end of 2021.1
Source: U.S. Department of the Treasury
There are unusual circumstances where the yield curve “inverts.” The use of this term does not necessarily indicate that the slope moves from higher to lower when reading the chart from left to right. But it can mean that yields on some shorter-term securities are higher than those for longer-term securities.
In 2022, the yield curve first inverted on April 1 when comparing two of the key indicator rates along the curve – the 2-year Treasury note and 10-year Treasury note.1 After a short period of time, yields reverted to a normal curve, but inverted again in early July. By September, the yield curve inversion between the 2-year and 10-year Treasury bond was even more dramatic.
Source: U.S. Department of the Treasury
On September 15, 2022, the yield on 2-year Treasury note closed at 3.87%. The yield on the 10-year U.S. Treasury note closed at 3.45%. When comparing those two maturities, the yield curve “inverted.”
Since this is a rare event, it tends to draw the attention of the financial press. Some analysts see the inverted yield curve as a key economic signal, with many speculating that it foretells a future recession.
Reading the tea leaves of an inverted yield curve
How significant is the inverted yield curve? “More than anything, it signals that the costs of taking on debt is going up and potentially exceeding the benefit of borrowing to make investments,” says Rob Haworth, senior investment strategy director at U.S. Bank. “It raises the possibility that corporations will be less likely to borrow in order to invest in new projects.” That has potential economic ramifications, though it’s not a clear indication that the economy is about to sink into a recession.
“The recent yield inversion between 2-year and 10-year Treasury bonds tells us the market is concerned about the risk of a recession,” says Haworth. “Yet this signal does not necessarily tell us that a recession is around the corner.” The yield curve inversion, even if it correctly predicts a recession, doesn’t tell us how quickly it may emerge. Yield curve inversions have occurred before the previous three recessions, but generally well in advance of the actual event. For example, the yield curve inverted 422 days ahead of the 2001 recession, 571 days ahead of the 2007-2009 recession and 163 days before the 2020 recession.2 In one instance in the 1960s, a yield inversion occurred and did not result in a recession, though the rate of economic growth did slow.3
The reliability of the inverted yield curve between 2-year and 10-year Treasuries as a recessionary signal is not one that is universally accepted. For example, in early 2022, two economists for the Federal Reserve (the Fed) issued a follow-up paper (to one first published in 2018) stating “it is not valid to interpret inverted term spreads as independent measures of a pending recession.” Their research raised questions about the predictive power of inverted yield curves between 2-year and 10-year Treasuries.4 As Haworth indicates, a bigger issue may be whether changes in interest rates have an impact on economic activity.
The Federal Reserve’s significant role
As the COVID-19 pandemic emerged in early 2020, the Fed reduced the short-term federal funds target rate to near zero percent, which helped keep rates on short-term government debt securities low. At the same time, the Fed began making monthly purchases of Treasury bonds and mortgage-backed securities, a step that helped moderate interest rates on the long end of the yield curve.
Once inflation emerged as a persistent concern in 2021, the Fed shifted its strategy. It eventually ended its bond purchases in March 2022 and began to reduce its more than $8 trillion in asset holdings, which could push long-term interest rates higher. At the same time, the Fed raised its target federal funds rate from near 0% prior to March 2022 to 2.25% to 2.50% by July. More rate hikes are expected later in 2022 and possibly into 2023. Haworth believes that as the Fed sets monetary policy, it’s paying close attention to the impact on interest rates to try to maintain a normal yield curve. He points out that the Fed has many tools available to try to influence yields at different maturities in order to effectively achieve its goals of cooling off inflation while avoiding a recession.
“More than anything, an inverted yield curve signals that the costs of taking on debt is going up and potentially exceeding the benefit of borrowing to make investments.”
- Rob Haworth, senior investment strategy director at U.S. Bank
Haworth is keeping a close eye on the relationship between 3-month U.S. Treasury bills and the 10-year Treasury note. “If the yield curve between the 3-month and 10-year Treasury is inverted for a period of weeks, that may be a more significant signal of a potential recession,” says Haworth. “The 3-month rate has more impact on economic activity, such as corporate borrowing trends, than the 2-year Treasury yield.” Notably, the spread between the 3-month and 10-year Treasury narrowed considerably in 2022. The spread (or yield difference) was 1.47% at the end of 2021 (meaning the 10-year Treasury yielded 1.47% more than the 3-month Treasury). By September 15, 2022, the spread narrowed to less than 0.25%.
Where the economy goes from here
The direction of the U.S. economy for the remainder of 2022 has become a bit cloudier in recent months. After growing rapidly in 2021, the economy (as measured by Gross Domestic Product) declined by an annualized rate of 1.6% in the first quarter, and 0.9% in the second quarter of 2022.5 The Fed’s money tightening measures are designed to temper economic growth with the aim of slowing inflation. The question now is whether the Fed can succeed in its inflation-fighting strategy without pushing the economy into a recession.
Haworth is watching how corporations react to the inverted yield curve. Most companies appear to be in a strong financial position, with balance sheets holding up well and cash flow meeting their needs. To this point, he is skeptical that a short-lived yield inversion will play a major role in how most companies plan for the future. “Company decisions are made over time, not in a day, so a brief yield inversion is not likely to change a lot of business plans,” says Haworth.
Haworth says the big variable to watch is how corporations perform going forward. “If corporate earnings meet expectations, it’s an indication that companies still have power to raise prices. If not, it may be a sign that we’re closer to stemming the tide of inflation.” Alternatively, lower consumer spending that reduces demand could also accomplish cool the rise in the cost-of-living, but that might mean a greater chance of the economy tipping into a recession.
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