Last week, the carefully monitored yield differential between the 2-year and 10-year Treasury notes inverted. The yield on two-year Treasury notes reached 2.44 %, while the yield on 10-year notes was 2.38 %. 

What is a Yield Curve?

The United States Treasury funds government deficit expenditure by issuing debt securities with varying maturities. These span from 1 month to over 30 years.

Treasury rates vary in response to changes in demand and expectations for the economy. In a “primary market” auction process, competitive bidders determine yields, with prices inversely correlated to them. The Fed (Federal Reserve) establishes a target for the Fed Funds Rate and the Discount Rate in the very short term (overnight). Their policy of decreasing or raising those rates has an enormous impact, but they have no direct influence over the debt auctioning process.

The yield curve is a graphical representation of bond yields over different maturities. Longer-term bonds often pay higher interest rates to compensate investors for the greater risk they assume over time. The longer a bondholder has to wait to reclaim his principal, the more likely inflation will reduce the investment’s purchasing power, or the borrower will default.

Upward sloping yield curves are often connected with markets anticipating robust future economic expansion:

Long-Term Yield = Long-Run (Nominal) Growth + Term Premium

Investors expect a higher compensation for owning riskier long-term bonds rather than just rolling over their ownership of short-term bills. This compensation is known as a “term premium.”

Bonds with shorter maturities, on the other hand, are expected to yield less than bonds with longer durations. However, this relationship might be flipped at times.

Inverted Yield Curve

When the Fed’s policy is related to tightening and raising rates in the near term, the curve often flattens or even inverts. This indicates that investors are less optimistic about the economy’s long-term prospects and expect the Fed to decrease interest rates in the future to support the economy.

An inverted yield curve also can cause economic slowdowns. This is because refinancing loans in the short term becomes expensive. Banks usually borrow money in the near term and lend them out in the long run. When short-term interest rates exceed long-term interest rates, banks face pressures and become disincentivized to lend. This reduces economic activity.

The Predictive Power of the Inverted Yield Curve

Bond yield spreads are commonly used to assess the state of the economy. Greater spreads between long-term and short-term bonds result in an upward sloping yield curve, which can suggest positive economic prospects. Narrower spreads result in a flatter or even negatively curved yield curve, indicating weak economic prospects.

Over the previous 60 years, every recession in the United States has been preceded by at least a partly inverted yield curve. The delay has lasted anywhere from six to thirty-six months, with an average of 22 months.

Every inversion of the yield curve, on the other hand, has not been followed by a recession. As a predictor, an inverted yield curve suggests but does not guarantee a recession.

We should not base our investment decisions exclusively on the yield curve. The yield curve inversion can be benign and indicate only an economic slowdown but not a recession. There are a large number of variables involved in the picture.

Even if it can foresee an economic downturn, it doesn’t always mean that the inverted yield curve can help you time the market. It also does not indicate the severity of the recession. Furthermore, the Fed can still make efforts to forestall the decline.

Conclusion

According to several analysts, the Federal Reserve’s unusual intervention in bond markets has artificially lowered the 10-year Treasury rate. As a result, this case of an inverted yield curve isn’t particularly noteworthy.

The central bank anticipates that inflation will fall as supply bottlenecks in the economy relax. If inflation does not fall as expected and the central bank continues to raise interest rates until 2023 or beyond, a recession may become more of a worry than it is today.