What is an inverted yield curve?
Let’s say you wanted to loan out $100,000 for two years. How much interest would you want to collect? If you could get 5%, that’d be $5,000 per year. Not bad, but would it be worth the risk of possibly not getting paid back? Now imagine the borrower is the US government, a low risk in the opinion of most investors. Maybe 4% would be enough?
Let’s change the equation. What if your loan was to be for 10 years? Would you want a higher percentage of interest? Most investors would. After all, there is an opportunity cost depending on what else you might be doing with that money. But what if the market was offering you less for the 10-year loan than the 2-year loan? You might think that’s kind of crazy. And that is the essence of the inverted yield curve.
The chart above shows the difference between 10-year and 2-year treasury yields going back almost 50 years. The horizontal line is the zero bound so each time it dips below that, we see an inverted yield curve, meaning the 2-year is paying more than the 10-year. This has served as a reliable indicator of recessions, which are the vertical gray bars. Every recession shown here is preceded by an inverted or almost-inverted yield curve. And of course, there are quite a few predictions out there that we’ll be going into recession soon, if we are not already now there.
Is there anything else the yield curve could be telling us? In the case of this latest inversion, the message may have a silver lining. Today, it is reasonable to believe the shorter-term yield is higher largely because the Federal Reserve Open Market Committee has been raising rates aggressively to slow the economy. Yet, longer-term yields are not going up nearly as much. This is probably because bond investors think slower growth is more likely as we get beyond the next year or two.
Could this be good news for the market? It’s a mixed bag. Slow growth is not good for stocks or the economy. But sustained growth, even if a little sluggish, is better than contraction. If longer-term yields have any clues, we’ll be watching their moves. It could also mean the Fed’s aggressive hiking could be near an end.
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