Inverted Yield Curve

What Is An Inverted Yield Curve?

An inverted yield curve is a situation in which yields on shorter-term U.S. Treasury securities are higher than on longer-term bonds, a reverse of the traditional state of affairs, where yields are higher the longer the bond's maturity. Many economists and analysts view an inverted yield curve as a signal that the U.S. economy may be poised to go into recession, because lower yields on long-term Treasury bonds indicate that investors anticipate lower interest rates going forward as the result of a weaker economy.

What Is A Yield Curve?

The yield curve is a dotted line that tracks the yield to maturity on the full gamut of Treasury securities, from one-month bills to 30-year bonds and everything in between. The Treasury market is the largest bond market in the world. It generally sets the benchmark for yields on lots of other debt securities, which range from corporate bonds to consumer loans (such as home mortgages).

What Are Yields?

In normal times, yields are higher the farther out the maturity to compensate investors for the greater risk they assume for lending their money for a longer period of time. For example, in simplest terms, a 1-year bill may yield 1%, a 5-year note 2%, a 10-year note 3%, and a 30-year bond 4%.

Yields on Treasury securities change all day long based on market demand and scarcity, as do the differences in yield among the different maturities. These differences, or spreads, are watched carefully by economists, investors, and the Federal Reserve for what they may be saying about the U.S. economy.

Can An Inverted Yield Curve Predict A Recession?

An inverted yield curve has a fairly reliable track record in predicting the likelihood of U.S. recessions, with some sources claiming that inverted yield curves have preceded every economic recession over the past 70 or so years.

However, it doesn't predict exactly when such a recession will happen, nor how severe the downturn turns out to be, which mitigates its usefulness as an economic indicator to some people. For example, the previous yield curve inversion began in December 2005, but the Great Recession and the global financial crisis that followed didn't officially begin until two years later.^[1]

Indeed, since 1900, the interval between a yield curve inversion and the start of a recession has averaged nearly two years. Over the past six recessions, the lag has ranged from as few as six months to as long as 3 years.^[2]

"It is not valid to interpret inverted term spreads as independent measures of impending recession," U.S. Federal Reserve economists Eric C. Engstrom and Steven A. Sharpe wrote in a 25 March 2022 paper published on the Fed's website, entitled (Don't Fear) The Yield Curve, Reprise. "They largely reflect the expectations of market participants," they said.^[3]

The 2-10 Spread

The most widely-watched yield spread in the Treasury market as a possible sign of recession is that between the 2-year Treasury note and the 10-year Treasury note, popularly known in the market as "the 2-10 spread."

However, the two Fed economists argued in their paper that yields at the shorter end of the curve were a better indicator of economic downturns.

> "There is no need to fear the 2-10 spread," Engstrom and Sharpe said.^[3]

Fed Chair Jerome Powell agreed, according to comments he made to the National Association for Business Economics in March 2022. "I tend to look at the shorter part of the yield curve," Powell told the group.^[4]

Logic Behind Inverted Yield Curve Indicator

There are several reasons believers in the yield curve inversion theory point to in defending its effectiveness as a recession predictor.

First, beginning with its 15-16 March 2022 monetary policy meeting, the Fed began raising interest rates in order to fight off inflation that had risen to its highest levels since the 1980s. However, the Fed began signaling its intention to raise rates several months before that, dating back to late 2021. In anticipation, bond yields had already started to rise, as did rates on consumer loans tied to Treasury yields, such as the rate on long-term home mortgages.

Investors expect these rate increases to eventually slow economic growth—indeed, that is the Fed's intention—and possibly throw the economy into recession, either accidentally or deliberately, which will eventually lead to lower bond yields.^[1]

Another reason is that investors anticipating a recession shift some of their money from the stock market into bonds, attracted by the higher yields. This increase in bond buying eventually raises bond prices, which results in lower yields.

While an inverted yield curve doesn't by itself cause a recession, it may play a role in it. In a normal environment, when long-term interest rates are higher than short-term interest rates, banks borrow money short term and lend it out for longer terms, pocketing the difference, which is called the net interest margin. However, that math doesn't work when short-term rates are higher, so banks are disincentivized to lend, which restrains business activity.^[4]

Is The Fed Distorting Bond Market Yields?

There is a case to be made that in 2022 an inverted yield curve is being influenced to some degree by the Fed.

Since the 2008 financial crisis, the Fed has made unprecedented interventions in the financial markets. It has held its benchmark interest at or near zero for long periods of time and purchased trillions of dollars of U.S. Treasury and U.S. government-insured mortgage-backed securities in order to ease credit conditions.

In September 2008, the Fed began to increase the size of its balance sheet from less than US$1 trillion to more than US$4 trillion by 2014, holding fairly steady at that level for the next 5 years. Following the COVID-19-inspired economic lockdown in March 2020, the Fed more than doubled the size of its bond portfolio to nearly US$9 trillion, which is where it stood as of April 2022.^[5]

Economics Argue Fed Intervention Distorts Market

That level of Fed intervention, to some economists, is distorting normal market activity, so the yield curve can't be relied on to give an accurate barometer of the economy. For example, the annual rate of consumer price inflation reached 8.5% in March 2022.^[6]

However, the yield on the 10-year U.S. Treasury note—considered the bond market's long-term benchmark—was only 2.6%.^[7]

Normally, the yield on long-term bonds would more closely approximate the rate of inflation, but the level of Fed holdings keeps yields on long-term bonds relatively low.

"Don't fear yield curve inversion," said Ethan Harris, head of global economics research at BofA Securities. "It is not the standalone indicator of recessions as it once was." He argues that, while an inverted yield curve has been the "most reliable standalone indicator" of a recession, today it is "heavily distorted by the Fed's massive balance sheet and extremely low bond yields overseas."^[8]

"Our models show the flatness of the curve could be more a consequence of the Fed's relentless buying of bonds, and the consequent growth of their balance sheet, rather than because of a looming growth shock," adds Dr. Ed Yardeni, president of Yardeni Research.^[2]

Summary

An inverted yield curve occurs when yields on shorter-term U.S. Treasury securities are higher than on longer-term bonds, a reverse of the traditional state of affairs, when yields are higher the longer the bond's maturity. An inverted yield curve often signals the onset of a recession, although it doesn't indicate when the recession may occur or its severity. It also doesn't cause recessions.

Some economists believe that unprecedented intervention by the Federal Reserve in the bond market since the Great Recession and the COVID-19 pandemic distorts bond yields, thus diminishing the yield curve as a reliable forward indicator of a downturn in today's environment.