- When coupon payments on shorter term Treasury bonds exceed the interest paid on longer term bonds, the result is an inverted yield curve.
- This occurred frequently in 2022.
- Some market observers consider a yield curve inversion a harbinger of economic recession.
Investors look for indicators that might offer insight into future economic trends. One potential signal that some consider a telltale sign is an “inverted yield curve,” when interest paid on shorter term U.S. government-issued bonds exceeds the interest on longer term bonds. While it may sound like an arcane event, an inversion of the yield curve could be a warning signal for the U.S. economy.
What is an inverted yield curve?
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) but with different maturities.
A simple way to view the yield curve is to look at current interest rates, or yields, paid by U.S. Treasury securities with maturities of three months, two years, five years, 10 years and 30 years. Investors typically expect to be rewarded with higher yields for investing their money for longer periods of time. This is referred to as a normal yield curve, one where yields rise along the curve as maturities are extended. The chart below depicts a normal, upward sloping yield curve among these five U.S. Treasury securities, which is where things stood at the end of 2021.1
Source: U.S. Department of the Treasury
There are unusual circumstances where the yield curve “inverts.” The use of this term does not necessarily indicate that the slope moves from higher to lower when reading the chart from left to right. But it can mean that yields on some shorter-term securities are higher than those for longer-term securities.
In 2022, the yield curve first inverted on April 1 when comparing two of the key indicator rates along the curve – the 2-year Treasury note and 10-year Treasury note.1 After a short period of time, yields reverted to a normal curve, but an inversion between the 2-year and 10-year Treasuries occurred again in early July and continued through November. In late October, the yield on the very short-term 3-month Treasury bill moved above that of the 10-year Treasury note and remained in that position through November.
Source: U.S. Department of the Treasury
At the end of November, the yield on the 3-month Treasury bill was 4.37% while the 2-year Treasury note closed at 4.38%. By comparison, the yield on the much longer-term 10-year U.S. Treasury note was 3.68%. As a result, there was an inversion not just between 2-year and 10-year Treasuries, but also between 3-month and 10-year Treasuries.
Some analysts see this rare event as a key economic signal, with many speculating that it foretells a future recession. Rob Haworth, senior investment strategy director at U.S. Bank, believes the inversion of yields between the 3-month and 10-year is even more notable. “With the yield curve between the 3-month and 10-year Treasury inverted for a period of weeks, that may be a more significant signal of a potential recession,” says Haworth. “The 3-month rate has more impact on economic activity, such as corporate borrowing trends, than the 2-year Treasury yield.” As Haworth indicates, the unknown factor is the degree to which changes in interest rates have an impact on economic activity.
Signs of a recession?
How reliable is the inversion of 3-month and 10-year Treasury yields as a recession indicator? “It’s hard to know for certain, but historically, when we see such a significant inversion, it typically points to a recession,” says Matt Schoeppner, senior economist, U.S. Bank. “Banks tend to start pulling back from lending in this type of environment, and higher interest rates also dampen consumer borrowing.”
“Even without the inversion, there were expectations being built into many economists’ projections that we’ll experience an economic contraction in 2023.”
- Rob Haworth, senior investment strategy director at U.S. Bank
Haworth says the market already seems somewhat prepared for an economic downturn. “Even without the inversion, there were expectations being built into many economists’ projections that we’ll experience an economic contraction in 2023,” says Haworth. “But the deeper the inversion gets and the longer it lasts, the more the market will begin to anticipate a difficult recession.”
We haven’t yet reached that point. Haworth says there are specific factors that bear watching to determine the direction of the economy in the near term. “We’re seeing a clear slowdown in the housing market, with higher mortgage rates making homes less affordable,” says Haworth. “Now we have to watch what’s happening with personal incomes.” He believes the key signals about future economic strength will come down to an uptick in layoffs that ultimately leads to rising unemployment. Recent data shows the unemployment rate remaining below 4%, considered low by historical standards.2 That is one sign that we aren’t yet in a recession. “The economy is slowing to be sure,” says Haworth, “but the question is, how slow will it go?”
The Federal Reserve’s significant role
As the COVID-19 pandemic emerged in early 2020, the Fed reduced the short-term federal funds target rate to near zero percent, which helped keep rates on short-term government debt securities low. At the same time, the Fed began making monthly purchases of Treasury bonds and mortgage-backed securities, a step that helped moderate interest rates on the long end of the yield curve.
Once inflation emerged as a persistent concern in 2021, the Fed shifted its strategy. It eventually ended its bond purchases in March 2022 and began to reduce its more than $8 trillion in asset holdings, which could push long-term interest rates higher. At the same time, the Fed raised its target federal funds rate from near 0% prior to March 2022 to the 3.75% to 4.00% range by November. More rate hikes are expected later in 2022 and possibly into 2023. Haworth believes that as the Fed sets monetary policy, it’s paying close attention to the impact on the broader interest rate market in the hopes of reestablishing a normal yield curve. He points out that the Fed has many tools available to try to influence yields at different maturities in order to effectively achieve its goals of cooling off inflation while avoiding a recession.
Where the economy goes from here
The direction of the U.S. economy as we near the start of 2023 has become a bit cloudier in recent months. After growing rapidly in 2021, the economy (as measured by Gross Domestic Product or GDP) declined by an annualized rate of 1.6% in the first quarter, and 0.6% in the second quarter of 2022. However, GDP bounced back in the third quarter, growing at an annualized rate of 2.9%.3 The Fed’s money tightening measures are designed to temper economic growth with the aim of slowing inflation. The question now is whether the Fed can succeed in its inflation-fighting strategy without pushing the economy into a recession.
Haworth is watching how corporations react to the inverted yield curve. Most companies appeared to be in a strong financial position for much of 2022, but Haworth says corporate revenue and earnings will increasingly be under pressure. “There is less of a payoff from capital spending in the current interest rate environment,” says Haworth. “This could ultimately be one factor driving the economy toward a recession.”
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