What's an Inverted Yield Curve? How Does it Work & Why is It Important for Investors?

By Chika

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Last Updated: April 8, 2022

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The bond market flashed a warning sign for the U.S. economy when the spread between five-year notes and 30-year bonds inverted for the first time since 2006. This occurrence sent financial markets into a frenzy because the inverted yield curve has always been seen as a harbinger of a recession.

Using the inverted yield curve as a barometer, analysts at Bank of America stated that the recent rally in US equities “despite clearly weaker fundamentals" may be a bear trap for investors given warning signs coming from the bond market. 

So what does an inverted yield curve mean for retail investors and how can they position their portfolios appropriately to avoid getting caught on the wrong side of the market? Let's read on.

 

What is a Yield Curve?

The term yield curve refers to the relationship between the short- and long-term interest rates of fixed-income securities issued by the U.S. Treasury.

It is the way by which fixed-income investors decipher the relationship between yields across the different maturities of U.S. government bonds, from 3-month bills to 30-year bonds. The focus is usually on the yields of Treasury notes starting with the two-year and out to the 10-year note.

The yield curve slopes higher when the economy is robust and interest rates remain steady. This is because shorter-term bonds typically have lower yields while longer-term bonds have greater yields.

Longer termed bonds often attract a higher return from investors due to the risks associated with tying up money for longer periods, like inflation.

However, the yield curve is not constant because it is constantly shifting in response to the bond market's ups and downs, as traders try to gauge the effect of the economy on financial markets

 

What Is an Inverted Yield Curve?

There are three ways bond market players describe the yield curve: steepening, flattening, or inverted.

  • Steepening is when the gap between short- and long-term yields is rising
  • A flattening is when that gap is shrinking
  • An inversion is when short-dated bonds yield more than longer-term ones

From an economic perspective, an inverted yield curve is a noteworthy and uncommon event because it suggests that the near term is riskier than the long term.

In other words, investors do believe that the economy will grow in the near term and as such are demanding more interest for their capital. This is why investors get antsy when the yield curve flattens because it heightens the risk of an inverted yield curve,

 

Does an Inverted Yield Curve Predict Recession?

When it comes to the curve, the attention is usually on the difference between the two-year note yield and the 10-year note yield, sometimes called the “twos-tens spread” or a variation of that lingo.

Historically, an inversion of the two-year to 10-year yield curve has been a strong predictor of an impending recession. Officially, a recession is defined as two consecutive quarters of negative economic growth (as measured by the gross domestic product).

Since 1978, there have been six recessions recorded by the National Bureau of Economic Research, in which the yield curve inverted on average about 12 months prior to the recession’s start.

Some recessions take longer to develop than others, as exemplified by the August 2019 inversion and the start of the recession in February 2020 which was avoided because the Federal Reserve responded rapidly to decrease interest rates.

However, more recently, the viewpoint of the inverted yield curve being a bellwether for a recession has been called into question. This is because foreign purchases of securities issued by the U.S. The Treasury has created a high and sustained level of demand for products backed by U.S. government debt. 

When investors are aggressively seeking debt instruments, the debtor can offer lower interest rates. When this occurs, many argue that it is the laws of supply and demand, rather than impending economic doom and gloom, that enable lenders to attract buyers without having to pay higher interest rates.

 

Impact of an Inverted Yield Curve on Investors

An inverted yield curve exerts varied impacts on different asset classes. Let's have a look at some of them.

Mortgage prices

Homebuyers finance their properties with adjustable-rate mortgages (ARMs) which have interest-rate schedules that are periodically updated based on short-term interest rates.

When short-term rates are higher than long-term rates, payments on ARMs tend to rise. When this occurs, fixed-rate loans may be more attractive than adjustable-rate loans.

Credit

Lines of credit are also affected similarly because interest rates are based on short-term benchmark rates. As such, borrowers would earmark a larger portion of their incomes toward servicing existing debt.

This reduces expendable income and has a negative effect on the economy as a whole.

Fixed-Income

An inverted yield has the greatest impact on fixed-income assets because it eliminates the risk premium for long-term investments, allowing investors to get better returns with short-term investments.

When the spread between U.S. Treasuries (a risk-free investment) and higher-risk corporate alternatives is at historical lows, it is often an easy decision to invest in lower-risk vehicles.

As such, purchasing a Treasury-backed security would be prioritized over riskier assets such as junk bonds, corporate bonds, or real estate investment trusts (REITs).

Stocks

When the yield curve becomes inverted, profit margins fall for companies that borrow cash at short-term rates and lend at long-term rates, such as community banks.

This would lead to a sell-off in such stocks. Likewise, stocks of high multiple growth companies that have no feasible profit margins or string earnings growth would also fall because these companies cannot withstand periods of economic weakness.

As such investors favor defensive sectors and quality companies over riskier equities. 

 

The Bottom Line

While experts question whether or not the recent inverted yield curve is an indicator of pending economic recession, keep in mind that history is littered with portfolios that were devastated.

Smart investors ignore the noise and keep their focus on building their portfolios based on long-term thinking and long-term convictions—not short-term market movements.

However, for your short-term income needs, it is advisable to choose an investment with the highest yield, but keep in mind that inversions are an anomaly and they don't last forever. When the inversion ends, adjust your portfolio accordingly.

Photo by CALIN STAN on Unsplash

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