The term yield curve refers to the relationship between the short-term and long-term interest rates of fixed-income securities issued by the US Treasury Department. When short-term interest rates exceed long-term interest rates, a reverse yield curve appears. Under normal circumstances, the yield curve will not invert, because debt with longer maturities usually has higher interest rates than short-term debt.
From an economic point of view, the inversion of the yield curve is a noteworthy and unusual event because it shows that short-term risks are higher than long-term risks. Below, we will explain this rare phenomenon, discuss its impact on consumers and investors, and tell you how to adjust your investment portfolio to deal with it.
- The yield curve illustrates the interest rate of bonds with increasing maturity.
- When the yield of short-term debt instruments is higher than that of long-term instruments with the same credit risk profile, an inverse yield curve will appear.
- The inversion of the yield curve is unusual because long-term debt should bear greater risks and higher interest rates, so when they occur, they will have an impact on both consumers and investors.
- The inverted Treasury yield curve is one of the most reliable leading indicators of an upcoming recession.
Interest rate and yield curve
Normally, short-term interest rates are lower than long-term interest rates, so the yield curve slopes upward, reflecting higher returns on long-term investments. This is called the normal yield curve. When the spread between short-term and long-term interest rates narrows, the yield curve begins to flatten. During the transition from a normal yield curve to an inverted yield curve, a flat yield curve is often seen.
What does an inverted yield curve mean?
Historically, the inversion of the yield curve has been regarded as an indicator of the imminent economic recession. When short-term interest rates exceed long-term interest rates, market sentiment indicates that long-term prospects are poor, and the yield provided by long-term fixed income will continue to decline.
Recently, this view has been questioned because foreign purchases of securities issued by the U.S. Treasury Department have created a high level and continuous demand for products backed by U.S. government bonds. When investors actively seek debt instruments, debtors can offer lower interest rates. When this happens, many believe that it is the law of supply and demand, rather than an imminent recession and downturn, that enables lenders to attract buyers without having to pay higher interest rates.
The relatively few inverted yield curves are largely due to the longer-than-average interval between recessions since the early 1990s. For example, the economic expansions that began in March 1991, November 2001, and June 2009 were three of the four longest economic expansions since World War II. During these long periods of time, there is often the question of whether the inversion of the yield curve will happen again.
Business cycles, regardless of their length, have historically transitioned from growth to recession, and then back again. Prior to every recession since 1956, the inverted yield curve was a fundamental element of these cycles. Taking into account the consistency of this model, if the current expansion subsides to a recession, the yield inversion may form again.
The upward sloping yield curve is a natural extension of the higher risks associated with long-term bonds. In economic growth, investors also require higher yields at the long end of the curve to compensate for the opportunity cost of investing in bonds relative to other asset classes, and to maintain acceptable inflation spreads.
As the economic cycle begins to slow, it may be due to the Federal Reserve raising interest rates. As short-term interest rates rise, long-term yields remain stable or fall slightly, and the upward slope of the yield curve tends to flatten. In this environment, investors see long-term yields as an acceptable substitute for the lower return potential of stocks and other asset classes, which tend to increase bond prices and lower yields.
The formation of the inverse yield curve
As worries about the upcoming recession intensify, investors tend to buy long-term Treasury bonds on the premise that they provide a safe haven from the fall in the stock market, provide capital preservation, and have the potential to appreciate when interest rates fall. Due to the shift to long-term, yields may be lower than short-term interest rates, forming a reverse yield curve. Since 1956, the stock market has peaked six times after the start of the reversal, and the economy fell into recession within 7 to 24 months.
As of 2017, the most recent inverted yield curve first appeared in August 2006, when the Federal Reserve raised short-term interest rates in response to overheated stock, real estate, and mortgage markets. The inversion of the yield curve is 14 months earlier than the peak of the S&P 500 in October 2007 and 16 months earlier than the official start of the recession in December 2007. However, an increasing number of investment companies’ economic outlooks for 2018 indicate that the yield curve may be about to invert, citing that the spread between short-term and long-term Treasury bonds is shrinking.
If history has precedents, then the current business cycle will advance, and the economic slowdown may eventually become apparent. If the fear of the next recession rises to the point where investors regard buying long-term Treasury bonds as the best option for their portfolios, then the next inverse yield curve is likely to be formed.
The impact of the inverted yield curve on consumers
In addition to the impact on investors, the inverted yield curve will also have an impact on consumers. For example, home buyers use Adjustable Rate Mortgage Loans (ARM) to finance their properties, and their interest rate plans are regularly updated based on short-term interest rates. When short-term interest rates are higher than long-term interest rates, ARM’s payments tend to increase. When this happens, fixed-rate loans may be more attractive than adjustable-rate loans.
Credit lines are also affected in a similar way. In both cases, consumers must spend most of their income on repaying existing debts. This will reduce disposable income and have a negative impact on the entire economy.
The Impact of the Inversion of the Yield Curve on Fixed Income Investors
The inversion of the yield curve has the greatest impact on fixed-income investors. Under normal circumstances, long-term investment yields higher; because investors invest their funds for a longer period of time, they will get higher returns. The inverse curve eliminates the risk premium of long-term investment, allowing investors to obtain better returns through short-term investment.
When the spread between U.S. Treasury bonds (a risk-free investment) and alternative bonds of high-risk companies is historically low, investing in low-risk instruments is usually an easy decision. In this case, the yield of buying Treasury-backed securities is similar to the yields of junk bonds, corporate bonds, real estate investment trusts (REITs) and other debt instruments, but without the inherent risks of these instruments. Money market funds and certificates of deposit (CD) may also be attractive—especially when the yield on a one-year CD is comparable to the yield on a 10-year Treasury bond.
The Impact of Inverted Yield Curve on Stock Investors
When the yield curve is inverted, the profit margins of companies such as community banks that borrow cash at short-term interest rates and lend at long-term interest rates will fall. Similarly, hedge funds are often forced to take greater risks in order to achieve the level of return they want.
In fact, the wrong bet on Russian interest rates is largely due to the demise of Long-Term Capital Management, a well-known hedge fund run by bond trader John Meriwether.
Although it will affect some aspects, the inversion of the yield curve tends to have less impact on consumer staples and healthcare companies that do not rely on interest rates. This relationship becomes clear when an inverted yield curve emerges before the recession. When this happens, investors tend to turn to defensive stocks, such as stocks in the food, oil, and tobacco industries, which are usually less affected by the economic downturn.
- In 2019, the yield curve inverted briefly. The tight labor market and the inflationary pressure signal from the Fed’s series of interest rate hikes from 2017 to 2019 have raised expectations of economic recession. These expectations eventually led the Fed to give up on raising interest rates. This inversion of the yield curve marks the beginning of the 2020 recession.
- In 2006, the yield curve inverted for most of the year. In 2007, the performance of long-term government bonds continued to outperform stocks. In 2008, as the stock market crashed, long-term Treasury bonds soared. In this case, the Great Depression came, and the result was worse than expected.
- In 1998, the yield curve inverted briefly. In the past few weeks, the price of U.S. Treasuries has soared after Russia’s debt defaulted. The Fed’s rapid rate cut will help prevent a recession in the U.S. economy. However, the actions of the Federal Reserve may have contributed to the subsequent Internet bubble.
Although experts question whether an inversion of the yield curve is still a powerful indicator of an upcoming recession, remember that when investors undoubtedly follow the “this time different” forecast, history is full of portfolios. Recently, short-sighted stock investors have hyped this motto and participated in the “tech crisis” by snapping up stocks of technology companies at high prices, even though these companies have no hope of making a profit.
If you want to be a smart investor, please ignore the noise. Instead of spending time and energy trying to figure out what will happen in the future, build your portfolio based on long-term thinking and long-term beliefs—not short-term market trends.
For your short-term income needs, do the obvious: choose the investment with the highest yield, but remember that inversion is an anomaly and will not last forever. When the reversal is over, adjust your portfolio accordingly.