The yield on U.S. Treasury bonds been volatile this week as investors reacted to the news of another Federal Reserve rate hike. Although bond rates have recovered from an early drop, the yield on short-term Treasury debt now exceeds that of long-term assets. This has many investors worried about what’s known as an “inverted yield curve.”
And they’re worried because, historically, an inverted yield curve is one of the surest indicators of a recession.
One of the biggest stories dominating economic news is the so-called “hard landing” theory of inflation control. Put simply, this is the question of whether the Federal Reserve can get control of inflation without triggering a recession in the process.
When the Federal Reserve lowers its benchmark interest rate, the rate it charges for extending short term loans, it costs less for banks to get money. This makes it cheaper for banks to lend money themselves, increasing liquidity across the whole economy and, ideally, boosting employment. When the central bank raises this interest rate, the opposite occurs. Lending gets more expensive, which cuts the amount of money moving around the economy as a whole.
Increasing interest rates is how the Federal Reserve responds to inflation. Since inflation occurs when consumers want to buy more goods and services than the economy can provide, the Federal Reserve tries to reduce inflation by reducing that spending power.
The trouble is that reducing consumer spending power is also how an economy slips into recession. That’s is the heart of the current debate over interest rates. As of Wednesday, the Federal Reserve had increased its core interest rate six times to fight recent inflation. Most of those rate hikes have been 0.75 points, very high by historical standards.
This has caused many economists to ask whether the Federal Reserve can manage to curb inflation without also triggering a national recession, the “soft landing” solution in which the economy cools down enough to stabilize prices without reducing consumer demand enough to cause mass job loss. Otherwise, consumers should expect the “hard landing,” in which the central bank continues raising interest rates to and through a recession until prices come down.
At first these warnings were particularly driven by past experience. The last time U.S. inflation grew particularly hot was during the late 1970’s. To control it, the Reagan-era Federal Reserve Chairman Paul Volcker significantly increased the Federal Reserve’s interest rate, pushing it at high as 20% in 1981. (By contrast, the benchmark rate has currently reached 4%.) This contributed to, if not outright caused, a recession that cost one in 10 workers their jobs.
Yet today these expectations have been tempered by strongly mixed economic signals. Although inflation continues to grow in some sectors of the U.S. economy, it is also at historic highs in virtually all developed nations. At the same time, other major indicators such as employment, wage growth and even (recently) GDP growth remained strong. This has raised questions about which signals economists should credit to when analyzing the health of the economy, and strengthened arguments that the Federal Reserve might manage a soft landing after all.
But the emerging yield data on Treasury debt suggests that a recession may be imminent after all.
The term inverted yield curve refers to when short term Treasury debt pays higher yields than long term assets. This is a change, or inversion, from normal.
Ordinarily long term Treasury debt, such as the 5-year and 10-year notes, pays higher yields than short term debt. This is because investors are generally willing to pay less for assets that keep their money locked up for longer periods of time. Long term assets are subject to more volatility and, in particular, prevent an investor from pursuing other opportunities. Since investors pay less for long term assets, their price compares more favorably with their interest rate and they have a better yield compared with the more convenient, and so more expensive, short term assets.
For example, a 10-year Treasury Note will generally have a lower yield than a 1-year Treasury Bill. Investors would rather get their money back sooner, so they will pay more for the 1-year asset relative to its interest rate.
The yield curve refers to how the yield rates across the Treasury’s core debt products compare with each other. Ordinarily it should slope upward from left-to-right, as yields improve with each longer-term asset.
This curve is described as “inverted” when the relationship between long term debt and short term debt reverses. Short term assets begin to have a higher yield than long term assets because investors have begun paying more for long term debt. With higher prices relative to their underlying interest rate, the yield on long-term Treasuries dips below the now-cheaper short-term assets.
The yield curve was modestly inverted. The 10-Year Treasury Note, for example, paid a yield of 4.10%. This is less than that paid by the 6-Month Treasury Bill (4.57%), the 1-Year Treasury Bill (4.76%), or the 2-Year Treasury Note (4.61%).
The inverted yield curve can be a significant indicator of a recession.
Historically, an inverted yield curve often occurs shortly before a recession. Bond yields reversed in 1978, 1998, 2000 and 2006, in each case preceding a recession within a 12 to 18 months. This isn’t a perfect predictor. The yield curve also inverted in 1998 and 2018, in both cases without event, but it usually indicates economic problems.
The reason is because the yield curve shows how investors view the market. An inverted yield curve means that investors have begun to prioritize security over access to their money. They’re willing to pay a premium for assets that keep their cash safe and they’re willing to sacrifice short-term opportunities in the process. This suggests that, across the market, investors have grown concerned about losses and volatility in the coming months and years.
Does this mean that a recession is imminent in 2023? That’s more difficult to say.
The inverted yield curve is an important indicator. It has historically preceded recessions with a high degree of accuracy, and that’s nothing to ignore. Investors have begun to bet with their money that a recession is imminent and they’re looking for a safe place to ride it out. In tandem with rising interest rates and a tumbling stock market, these are warning signs for investors of all stripes.
Yet the inverted yield curve is not a perfect indicator. It correlates with recessions; it does not cause them, and it does not correlate perfectly. An inverted yield curve also does not signal the depth or strength of a recession, meaning that it can precede anything from small market losses to the 2008 collapse. Finally, the economy is currently filled with mixed signals. An inverted yield curve could signal trouble ahead, or it could show that investors have gone cautious in an era of confusing and contradictory markets.
For investors, this is nothing to ignore. This is not dispositive, but it is a warning sign.
The Bottom Line
With November’s most recent rate hike the talk of recession is growing louder. Perhaps the biggest sign that this could be real is happening in the bond market, where the Treasury debt yield curve has inverted.
Tips for Investors
- Yield curves apply to every area in the bond markets, not just to Treasury assets. Here’s how you can apply them to your everyday investing too.
- O.K., so a recession might be coming. Now what? With SmartAsset’s matching tool you can find a financial advisor in your area who can help you figure out your next move. Get paired with a financial advisor for free now.
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