Key takeaways

  • An unusual fixed income environment featuring an inverted yield curve persists.

  • This means that some shorter-term securities are paying higher yields than longer-term bonds.

  • The inverted yield curve emerged in late 2022, due in large part to interest rate hikes by the Federal Reserve.

Investors have been forced to adjust to an unusual dynamic in the U.S. bond market, as yields on short-term securities remain higher than those on 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 or two years.

Yet such a situation, referred to as a yield curve inversion, has been in place since October 2022. At that point in the current market cycle, yields on 3-month Treasury bills exceeded those of 10-year Treasury notes. Federal Reserve (Fed) actions have, in this circumstance, been primarily responsible for the yield curve inversion. 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 federal funds rate, which was near 0% in early 2022, was increased 11 times to a range of 5.25% to 5.50% by July 2023. Yields on shorter-term securities followed suit. While longer-term bond yields also moved higher, they didn’t rise as dramatically as did yields on shorter-term instruments.

 

Understanding the yield curve

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

Chart depicts a normal, upward sloping yield curve among five U.S. Treasury securities, depicting actual yields in the Treasury market at the end of 2021.
Source: U.S. Department of the Treasury, December 31, 2021.

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.

Chart depicts an inverted, downward sloping yield curve among five U.S. Treasury securities, depicting actual yields in the Treasury market as of February 20, 2024.
Source: U.S. Department of the Treasury, as of February 20, 2024.

The inversion today is flatter than it was during periods in 2023. As of February 20, 2024, the yield on the 3-month Treasury bill was 5.44%. By comparison, the yield was 4.27% for the 10-year U.S. Treasury note, a 1.17% spread. The spread, or yield advantage for 3-month Treasuries over 10-year Treasuries, was as high as 1.88% in May 2023.1

Graph depicts the differences in yields paid on 10-year U.S. Treasury bonds and 3-month U.S. Treasury notes as of February 20, 2024.
Source: Federal Reserve Bank of St. Louis. As of February 20, 2024.

The Fed’s role in yield curve dynamics

The major question for bond investors now is when will the Federal Reserve begin cutting the federal funds target rate. Fed officials have indicated that rate cuts will likely occur in 2024, but 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 longer the Fed is on hold with the fed funds rate,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management, “the longer we’re likely to see the inverted yield curve persist. It is most likely with us until the Fed begins to cut interest rates.”

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.”

According to Haworth, “Adjustments to the target fed funds rate most directly affect the shorter end of the yield curve.” Haworth notes that the market, at least temporarily, priced in rate cuts on longer-term bonds at the end of 2023, when yields on 10-year Treasuries dropped below 4%. He also points out that (as indicated in the Feb. 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. “That is likely to change based on the pace of Fed rate cuts.” After its January 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.2

 

Fading recession risks?

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 somewhat 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 most recent pronouncements from the Fed indicate that they believe inflation is mostly under control given the current state of the economy,” notes Haworth. “As it turned out, we didn’t need a recession to occur to get most of the inflation out of the economy.” He points out that strong wage growth is one area of the economy still presenting inflation concerns for the Fed.

Haworth also notes 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.” Even though borrowing costs have increased, 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.”.

 

Investment considerations in today’s unusual environment

With yields higher on short-term securities, it’s no surprise investors 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.” 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 any challenges in the months ahead.

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.

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

  2. Board of Governors of the Federal Reserve System, “Transcript of Chair Powell’s Press Conference Opening Statement, Jan. 31, 2024.”

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

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