Key Questions: The Yield Curve Has Un-inverted. Now What?

In the past few days, there has been a noticeable shift in the bond market that investors should pay attention to. Since July 2022, the yield on short-term bonds has exceeded the yield on long-term bonds. This is known as an inverted yield curve and is not normal. Most of the time, the yields on long-term bonds are higher than short-term bonds to serve as an incentive for investors to loan their money for a longer time horizon.

One of the most popular measures when discussing an inverted yield curve is the difference in yields between the 2-year Treasury note and the 10-year Treasury note (also referred to as the “2s10s curve”).  

Historically, when the 2s10s curve becomes inverted, it has foreshadowed a recession, and a downturn in the economy typically follows. This month, however, the yield curve has un-inverted. That is to say, the yield on the 10-year Treasury is outyielding the 2-year Treasury once again. This is good news, right? Unfortunately, we might not yet be in the clear of a recession.

What Is the Yield Curve?

The yield curve, a graphical representation of interest rates offered over different maturities, is a widely monitored indicator in finance and economics. Normally, as noted above, a yield curve is upward sloping, depicting longer-term bonds offering higher returns than shorter-maturity bonds. This makes sense because it reflects the risks and uncertainties associated with lending money for extended periods and investors demanding more for these uncertainties. However, when the yield curve inverts, it can signal that investors are more concerned about the immediate future and a recession may be on the horizon. This happened two years ago when investors feared that rampant inflation would pull the U.S. economy into a recession.

What Does History Tell Us?

Typically, a U.S. recession has followed within 24 months of an initial 2s10s yield curve inversion. Of the last six recessions the U.S. has faced going back to 1980, five were preceded by an inversion of at least 20 days. The exception here was the brief inversion in 2019, lasting only nine days. The predictive power of this inversion may be further complicated by the COVID-19 pandemic, but a recession did occur in 2020.

This most recent inversion marked the longest continuous inversion in history, with 25 consecutive months of the 2s10s yield curve being inverted, landing just outside the 24-month window. Even if the curve remains normalized, however, it doesn’t necessarily mean we will avoid a recession. The last four U.S. recessions in 1990, 2001, 2007, and 2020 started only after the curve turned positive. In each of these cases, the economic downturn began three to six months after the curve was un-inverted.

History tells us that when the Federal Reserve (Fed) raises rates aggressively, like what we saw in 2022 and 2023, it typically causes a recession. At the same time, though, when the Fed embarks on a series of rate cuts, it can be due to a recession or an attempt to thwart a recession. Simply put, both yield curve indicators can suggest a recession is on the way.

Is This Time Around Different?

While the shape of the curve should not be overlooked, what may be more important is why the underlying Treasury securities that make up the curve are moving the way they are. Over the past few months, short-dated Treasury yields have moved lower as the market expects the Fed to begin cutting rates for the first time since March 2020, and the Fed’s actions with respect to interest rates will have a direct impact on the front end of the curve. Fed funds futures show the market is pricing in at least four 25-basis-point (0.25%) cuts before year-end, and these expectations have driven shorter-maturity yields lower, specifically the 2-year Treasury yield, resulting in the yield curve un-inverting. 

At the same time, however, we have seen longer-dated Treasury yields also come down, hitting year-to-date lows. Longer-dated Treasury securities, such as the 10-year Treasury note, act as a barometer for the economy, reflect investor expectations for a longer time horizon, and aren’t as easily influenced by Fed monetary policy. A drop in these longer-dated yields can suggest a flight to quality as investors have become spooked about a weakened labor market.

Shifting the focus back to the Fed, some major questions remain for investors. How fast will the Fed cut and what are the main reasons behind these cuts? Suppose interest rate cuts are purely because of inflation dropping back to a level close to the Fed’s 2% target and gradual cuts are made. This is what many refer to as a “soft landing," which implies that a recession could be sidestepped. On the other hand, if the Fed is acting because of a weaker economy, particularly a weaker jobs market, the Fed may try to boost growth by cutting rates at a fast pace. This may not be ideal, and weak growth might result in a recession.

Conclusion

While there may be some comfort in a normal upward-sloping yield curve again, the un-inversion is not a guarantee of smooth sailing ahead, but rather an important turning point in understanding where the economy and financial markets may be headed. It warrants caution for investors who must remain vigilant, as even a normalizing yield curve can reflect a complex mix of factors, from monetary policy shifts to changing employment and inflation expectations.

This turning point can present an opportunity for investors to reposition their portfolios. We cannot say whether a recession is on the way, but one thing looks certain: The Fed will be cutting interest rates. This can be an opportunity for investors to put cash back to work and extend the duration of their portfolios. For further insights, please contact your investment professional.