You may have seen a news report or two in the past month or so about the “yield curve” being inverted. If you’re like most Americans, this report may as well have been in another language.
But even if you’re initially confused by the wording, this is not something you should ignore. In fact, this news may be portending some even worse economic developments. Before you get too worried, here are some answers to questions you likely have:
What is the Yield Curve?
In the world of finance, a yield curve refers to a graph that depicts how the yields on government bonds vary as a function of their years remaining to maturity. So, one axis will show the yield while the other shows the years remaining until maturity. The longer the holding period or term, the higher interest rate that the bond will pay. For example, traditionally, short-term bonds or T-bill will of a year or less will have a very low interest rate and the long-term bonds, like a 30-year will have the highest interest rate, which is attributable to the risk of holding the bond over time. This means that an investor is paid a higher rate of interest for buying an investment over a longer period.
What Do You Mean “Inverted”?
The yield curve typically slopes upward in the midst of normal economic conditions. This signals that short-term bonds provide less income to investors when compared to longer-held bonds, which will provide more income over the course of the maturity. An inverted yield is one that trends downward, meaning that investors earn less on securities that they plan to hold onto for longer.
That brings us to the current issue: two-year government bonds have been paying more than 10 years bonds over the course of the past year. In early July, that disparity was 4.94% to 3.86% yield in favor of short-term bonds, the biggest gap since the troubled economic times of the early 1980s.
Why is This Happening?
The biggest factor at play here is that short-term bonds are tied to the interest rate set by the Federal Reserve. Between March 2022 and July 2023, the Federal Reserve raised the interest rate 11 times, taking it from near zero to more than 5%. Fed officials have indicated more hikes are the way soon. This has resulted in short-term treasury bills and bonds having higher note rates than long term; the Yield Curve is inverted. The bond investors are predicting the economic troubles are shortly on the horizon and the United States Treasury has to pay a higher rate of interest to entice bond investors.
What Does This All Mean?
Unfortunately, an inversion of the US Treasury yield curve historically means that a recession is imminent. In fact, this phenomenon has happened ahead of every recession for more than 60 years. In this case, it likely indicates that investors are not confident the Federal Reserve can slow inflation without hurting the economy. This is not a cause for concern, but rather an indication to be prepared.