When coupon payments on shorter-term Treasury securities exceed the interest paid on longer-term bonds, the result is an inverted yield curve.
This unusual trend began in 2022 and continues as we near the end of 2023.
Inverted yield curves have sometimes preceded recessions in the past, but to this point, the economy has proved resilient.
Investors are in an unusual position of having the ability to earn higher yields on shorter-term debt instruments rather than locking money up for longer periods to generate higher interest income. This is what’s known as an “inverted yield curve.” It’s not unprecedented, but its occurrence is rare. Along with upending the normal state of the bond market, a yield curve inversion is considered by some as a warning signal for the U.S. economy, potentially the precursor to a recession.
A yield curve inversion occurred earlier in 2022 before a normal yield curve reasserted itself. Then later in 2022, it inverted again, and has remained inverted since. Yet the economy has maintained a slow but steady growth rate. Is there still a risk that the yield curve will correctly signal a looming recession, and how should investors respond?
The concept of the yield curve starts with bonds of different maturities and is often based on yields of U.S. Treasury securities. These are bonds of equal credit quality (all backed by the full faith and credit of the U.S. government) differentiated only by the duration to maturity.
A simple way to view the yield curve is to look at current interest rates, or yields, on U.S. Treasury securities with maturities of three months, two years, five years, 10 years and 30 years. Investors typically demand higher yields when they invest their money for longer periods of time. This is referred to as a normal yield curve, one where yields rise along the curve as bond maturities lengthen. The chart below depicts a normal, upward sloping yield curve among these five U.S. Treasury securities, depicting actual yields in the Treasury market at the end of 2021. At that time, the yield on 3-month Treasury bills stood at 0.05%, and moved progressively higher as maturities extended along the yield curve.
However, there are unusual circumstances where the yield curve “inverts.” The use of this term does not necessarily indicate that the slope moves consistently higher to lower throughout the yield spectrum when reading the chart from left to right. But it can mean that yields on some shorter-term securities are higher than those for some longer-term securities.
In late October 2022, the yield on the very short-term 3-month Treasury bill moved above that of the 10-year Treasury note. The inversion became more pronounced toward the end of 2022 and the spread widened in 2023. Interest rates paid by 3-month Treasury bills are now approximately 1.1% higher than those available from 10-year Treasury bonds.1
As of September 21, 2023, the yield on the 3-month Treasury bill was 5.57% while the 2-year Treasury note closed at 5.1%. By comparison, the yield on the much longer-term 10-year U.S. Treasury note was lower, yielding 4.49%.
The current inversion can be attributed in large part to the actions of the Federal Reserve (Fed). When inflation emerged as a major issue in 2021 and 2022, the Fed, in conjunction with one of its mandates to maintain price stability, began significantly increasing the short-term federal funds target rate it controls. This is one of the tools it has available to try to influence the economy. The fed funds rate, which stood near 0% in early 2022, was increased by 5.25% in a 16-month period.
With the Fed setting short term rates that high, similar trends occurred across the broader bond market. Yields on short-term securities (Treasury bills in the 3-month to 2-year range) rose significantly faster than those of longer-term Treasuries (such as 10-year and 30-year bonds). That trend persists as the Fed indicates it will hold the fed funds rate higher well into 2024, even though inflation has notably subsided since peaking in mid-2022.
Should a recession be expected to occur soon given the presence of a yield curve inversion? Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management, believes the inversion of yields between 3-month and 10-year Treasury securities raises some concern. “It represents a higher cost for corporations,” says Haworth. “With short-term rates so high, companies could become increasingly reluctant to borrow, as it is more challenging to realize a payoff when investing the borrowed capital in new equipment and facilities or added employees.” Yet to this point, the fact that such a slowdown has yet to occur may be a sign that corporations are not in dire need of issuing debt. “As a whole, corporations are not yet showing signs of distress when it comes to their debt load and continue to maintain strong balance sheets,” says Haworth.
“While bank lending has tightened, it’s not clear that it’s happening at a pace that is indicative of a recession.”
Matt Schoeppner, senior economist at U.S. Bank
Haworth also points out that the reliability of the inverted yield curve as a recession signal may be suspect. “We only have data going back less than 50 years, so the causality connection may not be infallible.”
Matt Schoeppner, senior economist at U.S. Bank, says there are reasons to watch economic trends closely. “Banks tend to start pulling back from lending in this type of environment, and higher interest rates also dampen consumer borrowing.” Schoeppner adds that while these factors are potential harbingers of an economic downturn, it’s not yet a foregone conclusion. “While bank lending has tightened, it’s not clear that it’s happening at a pace that is indicative of a recession,” says Schoeppner.
Haworth notes that the unique circumstances of the current economic environment may play a role in the economy’s resilient performance. “It’s important to remember that there was a significant amount of fiscal stimulus in the form of government payments to individuals and businesses that helped boost the economy,” he says, referring to government support programs during the early stages of the COVID-19 pandemic, which began in 2020. “Government stimulus, along with monetary stimulus by the Fed created unusual circumstances leading into the current yield curve inversion cycle.”
Haworth believes key signals about future economic strength will come down to whether labor market trends reverse, and unemployment rises. Recent data shows the unemployment rate remains below 4%, however, still lingering near a half-century low.2 To this point, steady consumer spending, buoyed by the strength of the labor market, has helped keep the economy on a growth trajectory. “Even if consumers have spent down savings and are taking on more debt, wage gains have been sufficient in this strong labor market to allow consumers to maintain a solid spending pace,” says Haworth.
From an investment perspective, Haworth notes short-term bonds can offer a more competitive alternative to other types of cash-equivalent investments. However, he also recommends investors consider longer-term bonds, with far more attractive yields today than they were at the start of 2022. “Investors who have been keeping money out of long-term bonds may want to position assets back toward a more normal allocation into that end of the market,” says Haworth.
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. “There is still some risk of rates moving higher,” says Eric Freedman, chief investment officer, U.S. Bank Wealth Management. “A 30-year bond is much more sensitive to interest rate movements than a 6-month bond.” 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,” according to Freedman. “It’s also a time to emphasize high credit quality.” Issuers with stronger credit ratings are likely to be in a better position to meet debt obligations should the economy face challenges in the coming months.
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