Key takeaways

  • When coupon payments on shorter-term Treasury securities exceed the interest paid on longer-term bonds, the result is an inverted yield curve.

  • The yield curve began to invert in 2022 and this unusual trend is even more pronounced today.

  • While often considered the harbinger of an economic recession, today’s unique environment may help avoid.

Topsy-turvy bond market dynamics continue, where some shorter-term government debt securities offer higher yields than those of longer-term bonds. This is what’s known as an “inverted yield curve.” While it may sound like an arcane term, it tends to draw the attention of investors. History suggests that a yield curve inversion is 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 persists today. 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?

 

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) 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.

chart depicts an inverted, downward sloping yield curve among five U.S. Treasury securities, depicting actual yields in the Treasury market as of July 6, 2023.

Source: U.S. Department of the Treasury.

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.

Yield inversions occurred periodically at various points along the yield spectrum beginning in April 2022. But in late October, 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 1.5% higher than those available from 10-year Treasury bonds.1

chart depicts an inverted, downward sloping yield curve among five U.S. Treasury securities, depicting actual yields in the Treasury market as of August 10, 2023.

Source: U.S. Department of the Treasury.

As of August 10, 2023, the yield on the 3-month Treasury bill was 5.54% while the 2-year Treasury note closed at 4.82%. By comparison, the yield on the much longer-term 10-year U.S. Treasury note was lower, yielding just 4.09%.

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 Wealth Management, believes the inversion of yields between 3-month and 10-year Treasury securities is particularly notable. “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.” Haworth indicates that this can be a precursor to a slowdown in economic activity.

However, the fact that such a slowdown has yet to occur may also be a sign that corporations are not in dire need of issuing debt. “We haven’t seen significant new corporate bond issuance in recent months,” says Haworth. “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.”

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.”

 

A resilient economy

Conflicting signals bear watching. “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 at U.S. Bank. “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.

Recession expectations were fueled in part by the Fed’s continued short-term interest rate hikes. Higher interest rates are a tool used by the Fed to try to slow economic growth and temper inflation. However, economic growth has been modest but resilient. On the heels of 2022’s 2.1% growth rate, the economy achieved annualized GDP growth of 2.0% in 2023’s first quarter and 2.4% in the second quarter.2

“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 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, leading to rising unemployment. Recent data shows the unemployment rate remains below 4%, however, still lingering near a half-century low.3 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.

 

The Federal Reserve’s interest rate influence

Beginning with the last recession, triggered by the onset of the global pandemic, 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. As the first chart above (from 2021) shows, yields on the shortest-term government securities were near 0%. 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.

Short-term rates in the broader bond market tend to respond to Fed monetary policy related to the target federal funds rate it controls. The Fed raised the fed funds rate from near 0% prior to March 2022 to a range of between 5.25% and 5.50% by July 2023. Since the Fed shifted its strategy, yields on 3-month U.S. Treasury bills jumped, from 0.01% at the end of 2021 to about 5.5% today. Further rate hikes have not been ruled out and Fed officials continue to insist they will maintain elevated interest rates for an extended period until annual inflation is closer to its target range of 2%.

Progress has been made. Inflation peaked at 9.1% for the 12-month period ending in June 2022. It since dropped to 3.2% for the 12 months ending in July 2023, but it remains above the Fed’s targeted 2% level.3 Haworth points out that short-term Treasury rates aren’t likely to decline significantly until the Fed reverses course and begins lowering the fed funds target rate. Therefore, any change in the shape of the yield curve will either be delayed, or require an upturn in long-term bond yields.

Can 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 have managed to maintain a strong financial position, but Haworth says corporate revenue and earnings will be under increasing pressure. “There is less of a payoff from capital spending in the current interest rate environment,” says Haworth. “This could ultimately contribute to slower economic growth.” Consumer spending is the other important factor affecting the economic outlook. To this point, says Haworth consumers have demonstrated resiliency despite the changing interest rate and inflation environment.

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.

Check-in with your wealth planning professional to make sure you’re comfortable with your current investments and that your portfolio remains consistent with your goals, feelings toward risk and time horizon.

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Disclosures

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  1. U.S. Department of the Treasury, Daily Treasury Par Yield Curve Rates.

  2. Source: U.S. Bureau of Economic Analysis.

  3. Source: U.S. Bureau of Labor Statistics.

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