The Yield Curve Is Disinverting. Why Should I Care?

The US Treasury yield curve has a long history of raising alarms among investors and economists. That’s mostly because when it’s flipped upside down from its usual upward slope in what’s called an inversion, traders start getting anxious about the health of the economy. Almost every recession since 1955 has been preceded by an inverted curve, except recently when it inverted in 2022. When the curve disinverts, or returns to its normal shape, as it did on Sept. 4, some say that could signal a downturn is soon approaching. Still, despite the 2022 inversion, a slump has yet to materialize. This has led some to again question whether the curve’s shape is a reliable harbinger of recession.

What’s a yield curve?

It’s a visual representation of the difference in the compensation investors will receive for choosing to buy shorter- versus longer-term debt. Most of the time, bond investors demand a higher return, or yield, for the greater uncertainty that comes with locking away their money for longer periods. So yield curves usually slope upward.

What changes in the shape of the curve matter most?

The most alarming developments are yield curve inversions. Economist Campbell Harvey showed decades ago in his research that the shape of the curve is linked to the path of economic growth. When the yield curve inverts — rates for short-term bonds exceed those of bonds with longer maturities — a US recession has historically followed. A yield curve flattens when the spread for longer-term bonds drops to zero — when, for example, the rate on 30-year bonds is no different from the rate on two-year notes. If the spread turns negative, the curve is considered inverted. (Conversely, when longer-term rates rise relative to shorter-term ones — and the spread widens — the market calls this “steepening.”)

Why is the curve shape important?

The yield curve has historically reflected the market’s sense of prospects for the economy, particularly inflation and what kind of policy the central bank is likely to adopt (whether it’s adding or removing stimulus, or trying to keep the status quo). Normally, elevated inflation would lead to an upward sloping curve, as rising prices prompt investors to demand greater long-term returns to offset the loss of purchasing power in the payments they eventually receive. But yield curves can invert when investors expect a recession resulting from the Federal Reserve policy lifting interest rates to tame inflation. That connection has made an inverted yield curve a closely-watched indicator of impending economic slumps, like the one that started in 2007. In particular, the spread between three-month bills and 10-year notes has inverted before each of the past seven US recessions.

What is the disinversion telling us?

A restoration of the normal upward slope of the yield curve, or disinversion, typically happens when the Fed starts to lower interest rates or markets start pricing in looming cuts. Since the central bank tends to ease policy when the economy hits a snag, some say such disinversions (instead of the inversion itself) often signal that a recession is imminent. Currently, interest-rate swaps show traders are pricing in over a percentage point of Fed rate reductions over the rest of 2024.

How many yield curves are there? 

You can calculate a curve between any two bonds issued for a different length of time, or tenor. The US Treasury, for instance, issues three-month bonds and 30-year bonds, with an array of other securities in between. Investors look at the spreads, or differences, between the rates at which those bonds are trading. They also consider the predictions embedded in futures contracts on similar bonds. The futures rate basically is the sum of the expected short-term rate that far in the future plus a term premium, which is the extra money that investors demand to lend for longer.

What do the differences between curves mean? 

That can be hard to say. Divergences can reflect the way different tenors capture different stages of the Fed’s monetary policy cycle. The shorter-term yield curve tends to eliminate complicating factors like term premium. Of course, it’s worth remembering that all yield curves reflect market speculation: In the words of Fed researchers, investors inferring the likelihood of recession by looking at the yield curve is “akin to market participants looking at themselves in the mirror.”

Source: bloomberg