Key takeaways
While interest rates seem poised for adjustments in 2024 – based on the likelihood of evolving Federal Reserve monetary policy – an unusual environment that emerged in 2022 persists today.
Yields on some shorter-term Treasury securities continue to exceed those of most longer-term Treasuries.
While this so-called “inverted yield curve” is viewed by some market observers as an indicator of potential recession, the economy today continues to prove resilient.
An unusual trend that emerged in 2022 affecting fixed income securities persists today, as yields on short-term Treasuries continue to exceed those of longer-term bonds. This is contrary to normal financial market logic where investors would expect to earn higher yields for committing to a longer-term investment. For example, investors typically expect to collect more for investing in a security that matures in ten or more years than from a security that matures in three months to two years. The impetus for this so-called “yield curve inversion” traces back to a significant shift in monetary policy in 2022 by the Federal Reserve (Fed).
When inflation first emerged as a major issue in 2021 and 2022, the Fed, as a function of its mandate to maintain price stability, increased the short-term federal funds target rate it controls. This is one of the tools the Fed uses to influence the economy. The Fed boosted the federal funds rate, which was near 0% in early 2022, to a range of 5.25% to 5.50% by July 2023. As a result, publicly traded bond yields moved higher across the board, with the most dramatic increases occurring among shorter-term instruments.
A simple way to view the yield curve is by comparing 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 investing their money for longer periods of time. This is referred to as a normal, upward sloping yield curve. In this scenario, yields rise along the curve as bond maturities lengthen. The chart below depicts a normal, upward sloping yield curve among these U.S. Treasury securities of varying maturities, 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, up to a yield of 1.90% on 30-year Treasury bonds.1
However, at rare times, the yield curve “inverts.” The use of this term does not necessarily indicate that the slope moves consistently higher to lower across 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 has continued since that time, though the shape of the curve has changed.
The inversion today is flatter than it was during periods in 2023. As of March 20, 2024, the yield on the 3-month Treasury bill was 5.47%. By comparison, the yield was 4.27% for the 10-year U.S. Treasury note, a 1.20% spread. The spread, or yield advantage for 3-month Treasuries over 10-year Treasuries, was as high as 1.88% in May 2023.1
The direction of the yield curve is likely to be highly dependent on Fed interest rate policy, says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Short-term bond yields are firmly anchored to the Fed’s rate moves.” Haworth notes that while 3-month Treasury bill rates held relatively firm in recent months, yields on 2-year U.S. Treasury notes and some longer-term bonds reflected investor anticipation of pending Fed rate cuts. For example, 2-year Treasury bill yields exceeded 5% in mid-October 2023. As speculation grew that Fed rate cuts could occur in early 2024, the yield dropped more than 1%, to 4.14%, by mid-January. However, as it became apparent the Fed was in no rush to begin fed funds rate cuts, the 2-year yield jumped back up to 4.73% in March.
While Fed officials have indicated that rate cuts will likely occur in 2024, the timing of those cuts is in question. Economic data released so far in 2024 has created more skepticism that rate cuts will happen in the near term. “The inverted yield curve is most likely with us until those Fed rate cuts begin,” says Haworth.
He also points out that (as indicated in the March 20, 2024, yield curve chart above), the yield curve between five-year and 30-year bonds has begun to return to a more normal slope. “The inversion at this point is just with the very low end of the yield curve in comparison to longer-term bonds,” says Haworth. After its March 2024 meeting, Fed chair Jerome Powell confirmed expectations that interest rate cuts were likely in 2024, a sign that the Fed is close to achieving its goals of taming inflation. However, he also made clear that “we are prepared to maintain the current target range for the federal funds rate for longer, if appropriate.”2
Some believe an inverted yield curve signals the potential for a recession. Haworth points out, however, that the reliability of the inverted yield curve as a harbinger of recession is questionable. “We only have data going back less than 50 years, so the causality connection may not be infallible.”
While some anticipated that a recession was on the horizon once the yield curve inverted, Haworth points out the inverted yield curve as a recession signal is questionable. “We only have data going back less than 50 years, so the causality connection may not be infallible.” The U.S. economy maintained steady growth since the Fed’s rate hikes began in early 2022, with real Gross Domestic Product (GDP) expanding at a rate of 2.5% in 2023.3 “The job market remains strong, and there are no signs of significant deceleration in economic growth,” notes Haworth. To underscore Haworth’s point, Fed officials now project the U.S. economy growing by 2.1% in 2024, only modestly below 2023’s growth rate.4
Haworth cautions that the current interest rate environment creates headwinds for business investment. “It represents a steeper cost for corporations. 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.” Despite this, Haworth recognizes that “many corporations are not yet showing signs of distress when it comes to their debt load and continue to maintain strong balance sheets.”.
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. “Investors who kept money out of long-term bonds may want to position assets back toward a more normal allocation into the longer-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. “A 30-year bond is much more sensitive to interest rate movements than a 6-month bond,” says Eric Freedman, chief investment officer at 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. This includes corporate bonds, municipal bonds (for tax-aware investors) and collateralized loan obligations. “These types of securities offer the potential for investors to enhance yields in a portion of their fixed income portfolios,” says Haworth.
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.
A yield curve plots the interest rates paid by bonds of comparable credit quality across various maturities. A Treasury yield curve provides a comparison of government-issued bond yields of different maturities. A typical yield curve will trace current yields for Treasury debt securities with yields of three months, two years, five years, ten years and 30 years.
Typically, investors expect to earn higher yields from bonds with longer maturities. In a normal environment, the yield curve will be upward sloping. For instance, that means the yield on shorter-term bonds will be lower than the yield on longer-term bonds. However, in certain circumstances, the yield curve inverts and slopes downward. In this environment, yields on short-term securities exceed those of long-term securities. While historically, such yield curves have been a predictor of a recession, to this point, that hasn’t happened in the current cycle since the yield curve inverted in 2022.
The yield on a U.S. Treasury security, its effective interest rate, indicates the income that will be generated for an investor when purchasing a bond. For instance, when investing $10,000 in a 10-year U.S. Treasury note with a 4% yield, the investor will be paid income of $400 per year. Bond yields are locked in when an investor purchases a specific security, but yields paid by newly-issued U.S. Treasury securities will vary on a day-to-day basis.
The Federal Reserve is focused on fighting inflation with monetary policy intended to slow consumer demand. Does this put the economy at risk of a recession?
A fresh look at managing your cash and investments in today’s changing interest rate environment can help support your pursuit of the goals that matter most to you.
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