What is an Inverted Yield Curve?

An inverted yield curve, also known as a negative yield curve, is when long-term government bonds, like ten-year Treasury notes, have a lower yield than short-term government bonds, like two-year Treasury notes, of the same credit quality. The yield curve is largely affected by the growth of the economy.

A healthy yield curve is when the rate on longer-term bonds is higher than shorter-term bonds. In a normal yield curve environment, short-term government bonds yield less than long-term government bonds as investors are expecting a lower return for their money because it is only tied up for a short period of time. When money is tied up for a longer time period, investors expect a higher return on their investment because they are unable to access it for an extended time frame. As the Fed continues to raise short-term rates, and the long-term bond rates continue to be slow to rise, the yield curve begins to flatten as the gap between short-term and long-term bonds shrinks.

If people think a recession is on the horizon, they expect the yield of short-term debt to drop drastically because the near-term view of the current economic state is negative. The yield curve will go from normal, to inverted; as people look towards the far away future as more optimistic, they eagerly purchase long-term debt as this is a safe harbor from falling equity markets, which in turn lowers the yield as overcrowding occurs. Therefore, the yield on short-term debt rises as the demand for it falls, because these need to have a higher yield to attract investors.

The yield curve flattening, and potentially inverting, does not in itself indicate we are doomed for a recession. However, if it does invert, this has historically been a very strong predictor of a recession. According to the San Francisco Fed, yield curve inversions have “correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession.”

As short-term rates rise and exceed long-term rates, this can directly impact consumers in the form of both equity and fixed income investments and can negatively affect adjustable rate mortgages and lines of credit. It is important to keep in mind longer-term goals in this type of environment and to not attempt to be a short-term market timer. Inversions have historically been a part of the economic cycle and will regulate over time.

If you want to discuss what these broader economic trends mean for your portfolio and whether you should make adjustments, contact us to schedule an appointment today.