Yield Curve Inversion

For the last 12 months, the stocks have returned about 3%, while interest rates have dropped significantly — long-term Treasury rates have gone from 3.1% to 2.6%. When interest rates drop, bond prices go up; therefore, we seen significant appreciation in bond holdings. With the drop in interest rates, one of the things that we hear about in the press regularly is that the “yield curve” is inverted, thus signaling a recession. What is an inverted yield curve, what causes it, and does it indeed signal a recession?

First, a yield curve is simply a plot of the current interest rates on Treasury bonds vs. the maturities of those bonds. In a typical yield curve the interest rates of short maturity bonds are lower than that of long maturity bonds. For example, exactly one year ago, the 3-month interest rate was 1.93%, while the 10-year interest rate was 2.83% — and interest rates rose sequentially as maturities increased from 3 months to 10 years. This is known as an upward sloping yield curve and is a very typical shape for a yield curve. 

An inverted yield curve is one where interest rates fall sequentially as bond maturities increase. For example, currently if we look at the bond markets, the 3-month interest rate is 2.35%, while the 10-year interest rate is 2.14%. The yield curve does not have its usual upward sloping shape — it is downward sloping, or inverted. The financial press has taken this as an omen of an oncoming economic recession. Is this really true?

To answer the question of what an inverted yield signifies, we need to first recognize that the yield curve moves every day (as well as every hour, and every minute). Interest rates at all maturities are constantly changing, and therefore the yield curve is constantly changing.

The changes in the yield curve can broken down into two broad categories of changes: 1) changes in the level of the yield curve, and 2) changes in the slope of the yield curve. A change in the level of the yield curve causes all (or almost all) interest rates to move in one direction, high to low for example. These are also commonly known as parallel yield curve moves. A change in the slope of the yield curve causes the yield curve to change from upward sloping to downward sloping or vice versa. These are commonly known as twists of the yield curve.

Changes in the level of the yield curve are typically dictated by the market’s expectations of future economic conditions. For example, if the economy is expected to perform well over the next several years, then stocks will also be expected to perform well. In this case, demand for holding stocks today will increase. As demand for holding stocks increases, money flows into stocks. But where does this money come from? It comes from investors selling their holdings of bonds. Bonds prices do not perform as well as stock prices when the economy is expected to perform well, so investors sell their bond holdings and move money into stocks. This selling of bonds causes bond prices to drop and, therefore, interest rates to increase. This increase in interest rates occurs across all maturities, and so, the level of the yield curve shifts upward. So, as the market’s expectations of future economic performance increases, the yield curve shifts upward. The exact opposite happens when the market expects bad future economic performance. Investors prefer the safety of bonds (with a known interest rate), rather than the risk of stocks, which they are expecting to perform poorly due to the anticipated poor economy. So, they sell their stock holdings and buy bonds. The buying pressure on bonds causes bond prices to increase, which in turn causes bond yields to decrease across all maturities — the yield curve shifts downward.

In the market conditions we used earlier, the 10-year interest rate exactly one year ago was 2.83%. Now it is 2.14%. This decrease has occurred across almost all of the maturities of bonds. So, based on the example above, we can conclude that the markets are anticipating poor economic performance coming up, i.e., they are anticipating a slowdown in the economy, and possibly a recession.

However, the financial press is currently talking about an inverted yield curve, the fact that the yield curve currently is downward sloping. What causes the yield curve to change from upward sloping, like it was a year ago, to downward sloping, as it is today? In our example, the reason the yield curve became inverted is that the 3-month interest rate did not behave the same way as the longer maturity interest rates. The 3-month interest rate increased, from 1.93% to 2.35%. Why did investors sell ultra short-maturity bonds while buying all the longer maturity bonds? The answer to this comes from understanding who the investor is at the very short maturities. By far, the largest investor, dwarfing the market at the ultra short-maturity point, is the US central bank, otherwise known as the Federal Reserve. The Federal Reserve operates by setting the interest rate at the ultra short maturities, commonly referred to as the short end of the yield curve. Because the Federal Reserve has such enormous power at the short end of the yield curve, no amount of buying or selling by other investors affects the ultra short-maturity interest rates. 

So, a change in the slope of the yield curve generally comes about from a disagreement between the markets and the Federal Reserve. Over the last year, the markets as a whole have become very negative in terms of their expectations of future economic performance. That is why stocks have fared so poorly, returning only 3% in the last year. As investors sold stocks, they bought bonds of all maturities. This buying of bonds caused interest rates to drop across all bond maturities. So, the level of the yield curve dropped. However, the Federal Reserve disagreed with the market’s forecast, and they felt the economy would do well. Consequently, they increased interest rates at the ultra short maturities of the yield curve by effectively selling bonds. And due to the size and power of the Federal Reserve, no amount of normal investor buying of bonds at the ultra short maturities could reverse this. As a result, while the rest of the yield curve was dropping, the ultra short-maturity yields increased — the yield curve twisted, with the long maturity yield coming down, and the short maturity yield going up. And that is how we ended up with the inverted yield curve we have today.  

As to who is right about future economic performance, we won’t know for a while. But this disagreement between the markets and the Federal Reserve is what causes an inverted yield curve. It is this disagreement that the White House refers to whenever we hear criticism from the Executive Branch about the Federal Reserve. The Fed’s expectations are running counter to the markets, and therefore, if we are indeed on the verge of a recession the Fed is doing nothing to stop the recession and, in fact, their interest rate policies may even tip us over the brink into a recession.

In summary, an inverted yield curve tells us two things. First, the fact that interest rates have dropped across almost all maturities tells us that the market is expecting poor upcoming economic performance. Second, the fact that the interest rate has not changed and possibly increased at the ultra short maturities indicates that the Federal Reserve is in disagreement with the market’s expectations about poor economic performance. So an inverted yield curve is telling us that the market is expecting poor economic performance and that the Federal Reserve is not going to help boost economic performance because its view is that the economy will do well.