Haworth says the rate spread is dependent on Fed actions. “The inverted yield curve is most likely with us until those Fed rate cuts take hold.”
The inversion between the two-year and 10-year Treasury, often considered a signal of a pending recession, was the longest period of an inverted curve in history.2 Yet no recession has occurred in that time. “Market wisdom is that when the yield curve reverts to normal, a recession begins. But to the extent that occurred in the past, if was only coincidence,” says Haworth. Notably, the U.S. economy grew at annualized rates of 1.4% in 2024’s first quarter and 3.0% in the second quarter. Haworth believes there are no immediate recession fears on the horizon. “As the Fed begins to lower rates, it eventually reduces economic pressure.” But he notes that longer-term rates, such as 10-year Treasury yields which are more closely linked to mortgage rates, may remain somewhat elevated. That may offer little relief for the sluggish housing market.
How the yield curve could change
The next question is when to expect a return to a normal, upward sloping yield curve, when long-term bond yields exceed those of shorter-term bonds. Haworth sees two different scenarios, one preferred over the other.
“If long-term bond yields begin to fall, it likely reflects declining inflation. As that occurs, the Fed will feel more comfortable cutting short-term rates.” Haworth believes that the preferred way to see the yield curve return to normal is with short-term rates declining more precipitously than long-term rates. Declining short-term Treasury yields would likely follow fed funds rate cuts.
Haworth says the “Goldilocks” version of this scenario is one where declining inflation is paired with a growing economy. “In this circumstance, the Fed will feel more confident about its ability to lower rates without risking a significant inflation uptick.”
A less desirable scenario, according to Haworth, is one where the economy appears at risk. “The Fed will cut short-term rates to offset a recession threat,” says Haworth. “That could happen, for example, if unemployment suddenly moves sharply higher, which could curtail consumer spending and trigger a recession.”
“At this point, Fed rate cuts aren’t meant to stimulate economic growth,” says Haworth. “The Fed’s goal is likely to get interest rates back to what they consider to be a neutral level so the economy can remain at a normal growth rate.”
Investment considerations in today’s unusual environment
With yields higher on short-term securities, it’s no surprise investors have put significant sums to work on the short-end of the yield continuum. However, Haworth recommends investors also consider longer-term bonds, with yields that are far more attractive today than they were at the start of 2022. “The market is pricing bonds with the expectation of coming Fed rate cuts,” says Haworth. “People who don’t intend to keep money in cash over the long term should implement a plan to start migrating money out of cash and into longer-term bonds.”
One consideration for bond investors is the risk of rising interest rates. When interest rates rise, values of bonds held in an existing portfolio lose market value. “A 30-year bond is much more sensitive to interest rate movements than a 6-month bond,” says Eric Freedman, chief investment officer for U.S. Bank Wealth Management. Yet Freedman believes attractive interest rates create opportunities for investors. “It may be a time for fixed income investors to spread out exposures across the maturity spectrum.”
Haworth notes there’s increasingly positive investor sentiment for non-Treasury segments of the market. With certain non-taxable portfolios, this includes non-government agency issued residential mortgage-backed securities, while managing total portfolio duration using longer-maturity U.S. Treasuries. Certain tax-aware portfolios can benefit from municipal bonds, including some longer-duration and high-yield municipal securities. Trust portfolios may benefit from reinsurance as a way of capturing differentiated cash flow with low correlation to other portfolio factors such as economic trends.
Check-in with your wealth planning professional to make sure you’re comfortable with your current mix of investments and that your portfolio’s asset allocations remain consistent with your goals, risk appetite and time horizon.