Everyday investors likely don’t pay too much attention to the so-called “yield curve,” which financial professionals use to compare the yields on similar bonds across short- and long-term maturities.
So when the yield curve does make headlines, it’s generally because it’s setting off some alarm bells among market watchers.
It’s been a year since the yield curve for Treasurys “inverted.” In general terms, that means short-term bonds are paying higher interest rates than long-term bonds. Earlier this week, the disparity between two bonds in particular was the largest investors had seen since 1981.
Essentially, the curve had been inverted, and now it’s even more so.
So what’s the big deal? An inverted yield curve is a classic signal that a recession is on the horizon.
“In fact, since 1978, the yield curve has inverted six times (not counting the current inversion period) and has preceded a recession each time,” Megan Horneman, chief investment officer at Verdence Capital Advisors, wrote in a recent note.
Here’s what you need to know this time around.
What’s the yield curve again?
The yield curve is an easy, graphic way to understand the difference between yields on a particular type of bond across various maturities. Under normal economic circumstances, the curve trends upward: short-term bonds provide less income to investors because holding an investment for a shorter time involves less risk.
A downward-tending or “inverted” yield curve means that you earn less on securities that you plan to hold for longer, and is a sign that something in the economy is amiss.
Which specific bonds are we looking at?
When you’re reading about the yield curve, it almost always refers to rates paid by short- and long-term U.S. Treasurys. Different market analysts like to use bonds of different maturities as proxies for a short-term and long-term bond, but by far the most popular are the 2-year and 10-year treasury.
Two-year government bonds have been paying more than 10-year bonds since July 5, 2022. On Monday, the 2-year treasury yielded 4.94% versus a 3.86% yield on a 10-year bond. That disparity was the greatest in 42 years.
Why has the yield curve inverted?
Yields on short-term bonds are pegged to the interest rate set by the Federal Reserve. Over the past year and change, in an effort to combat rampant inflation, the central bank embarked on a series of hikes to its benchmark interest rate, which has risen from near zero to a range of 5% to 5.5%.
In the meantime, a chunk of investors have grown skittish about the economy, worrying that the Fed’s aggressive rate hike regime could slow the economy to the point that it tips into recession.
In those scenarios, “traditionally, government bonds have been a safe haven,” says Sam Stovall, chief investment strategist at CFRA. “The U.S. government doesn’t go out of business, but shaky companies do. Even pretty stable companies experience challenging times during recessions.”
By flocking to long-term government bonds, investors drive up the price of those investments. And because bond prices and interest rates move in opposite directions, long-term Treasurys have seen a decline in yield.
Why does an inverted yield curve signal a recession?
One explanation for why an inverted yield curve is a bad sign for the economy is straightforward and mathematical. “Primarily, it’s because it slows bank lending activities,” says Stovall.
“Banks make money by borrowing short and lending long,” he says. That means, typically, the bank takes money you deposit at a low rate and lends it out to people who want longer-term loans — “people buying a car, buying a house or a business looking to expand operations” — at a much higher rate, Stovall says.
An inverted yield curve makes the math unprofitable for banks in many cases. That means they’re more reluctant to lend to businesses, which have a harder time expanding, which slows the economy.
But in another sense, an inverted yield curve presaging a recession is sort of a self-fulfilling prophecy. By moving money out of short-term bonds and into longer-term ones, investors are expressing the belief that an economic slowdown is coming sooner rather than later.
Should investors be worried about the yield curve now?
Going back to 1978, it takes about 15 months on average for the economy to enter a recession after the yield curve inverts, according to Horneman’s analysis. “Applying this timeframe to the current inversion (roughly one year ago) the economy could enter a recession in October of this year.”
Still, past performance is no guarantee of future results. And even past performance can be a little misleading. The last time the yield curve inverted was 2019. A short recession did follow, but there were some other major forces acting on the economy at the time.
And while some recession indicators are flashing a red light for investors, others are green as can be. After all, the stock market is up a robust 16% on the year — hardly a reflection of a pessimistic market.
Overall, you’d be wise to put any short-term yield curve news into the context of your longer-term plans, says Stovall.
“I think a lot of people are morphing from an ‘oh no’ sentiment to a ‘FOMO’ sentiment. Don’t get caught in either one,” he says. “Maintain your dollar-cost averaging approach and realize that, more times than not, the market goes up.”
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