Current Inverted Yield Curve: A Comprehensive Guide to the Market

The current inverted yield curve is a significant market phenomenon that has left many investors and economists scratching their heads. An inverted yield curve occurs when short-term interest rates are higher than long-term interest rates.

This has happened five times since 1950, with the most recent instance being in 2019. The yield curve has been inverted for a record 24 weeks, which is a sign of economic distress.

Investors are watching the yield curve closely as it can be a precursor to recessions. In fact, every recession since the 1950s has been preceded by an inverted yield curve.

The yield curve is a graphical representation of yields on similar bonds across various maturities, also known as the term structure of interest rates.

Analysts often simplify the task of interpreting a yield curve by focusing on the spread between two maturities, which can help identify an inversion.

An inverted yield curve occurs when long-term interest rates drop below short-term rates, indicating that investors are moving money away from short-term bonds and into long-term ones.

This suggests that the market as a whole is becoming more pessimistic about the economic prospects for the near future.

The U.S. Treasury publishes daily Treasury bill and bond yields that can be charted as a curve, providing valuable data for analysts to work with.

An inversion has served as a relatively reliable recession indicator in the modern era, as it has often preceded recessions.

The yield curve has inverted ahead of every single one of the last seven recessions. This is a concerning trend.

In fact, the yield curve has inverted for the first time in a decade, specifically on December 3, 2018.

The current inverted yield curve is a complex issue with several causes and effects. One major cause is the global economic slowdown, which has led to a decrease in demand for goods and services, causing companies to borrow less and invest less.

The inverted yield curve is also a result of the US Federal Reserve's decision to raise interest rates, making borrowing more expensive. This has led to a decrease in borrowing and spending, which in turn has slowed down economic growth.

The effects of the inverted yield curve are far-reaching, with one major consequence being a potential recession. This is because an inverted yield curve has historically been a predictor of a recession, with a 90% accuracy rate, as seen in the 2000 and 2008 recessions.

The yield curve becoming inverted is a complex phenomenon with several explanations.

One key reason is the "expectations theory", which suggests that investors expect lower interest rates in the future, often due to an impending recession. This expectation causes the yield curve to invert.

Investors who value interest income may try to lock in long-term yields to protect their income stream, which drives up the prices of longer-term bonds and reduces their yields.

The 10-year to 2-year spread is a crucial indicator of recession risk. Many investors use it as a proxy for the yield curve, and it's considered a relatively reliable leading indicator of a recession.

Federal Reserve officials have argued that focusing on shorter-term maturities, like the 10-year to 2-year spread, is more informative about recession likelihood. This is because it's a more sensitive measure of market expectations.

Investors often look at the spread between the yields on 10-year and two-year U.S. Treasury bonds, as it's seen as a reliable indicator of recession risk. This spread has been studied extensively in academic research.

The 10-year to 2-year spread is a key metric for gauging recession risk, according to Federal Reserve Chair Jerome Powell. He prefers to focus on the difference between the current three-month Treasury bill rate and market predictions 18 months later.

The inverted yield curve is a topic of much debate among investors, with some believing it signals economic turmoil and others thinking it indicates confidence in the economy's recovery from inflation.

Historically, protracted inversions of the yield curve have preceded recessions in the U.S. An inverted yield curve reflects investors’ expectations for a decline in longer-term interest rates as a result of a deteriorating economic performance.

Going back to 1978, it takes about 15 months on average for the economy to enter a recession after the yield curve inverts, according to Horneman's analysis. This means the economy could enter a recession in October of this year, roughly 15 months after the current inversion.

The stock market is up a robust 16% on the year, hardly a reflection of a pessimistic market.

The current inverted yield curve is not an isolated phenomenon, but rather a symptom of a larger economic trend.

Historically, the yield curve has inverted several times since the 1960s, with the most notable instances occurring in 1973, 1980, and 2000.

These inversions have often preceded recessions, with the 2000 inversion leading to the dot-com bubble burst and the 2007 inversion leading to the global financial crisis.

The current yield curve inversion is a warning sign that economic growth may be slowing down, and investors are becoming increasingly cautious.

In many countries outside the US, inverted yield curves have been a recurring phenomenon. German bonds had an inverted yield curve in 2008, a sign of economic trouble. This was followed by negative interest rates in 2014, a policy implemented to stimulate the economy.

The UK also experienced an inverted yield curve, with 50-year bonds showing a negative yield in 2010. This was a result of the European sovereign debt crisis. Canada's bond market saw a similar trend, with 30-year bonds inverting in 2008.

Portugal's 30-year bond yield inverted during the European sovereign debt crisis, and the country's bond prices plummeted. Ireland's bond market also suffered, with an inverted yield curve in 2011 and negative interest rates after the crisis.

In Russia, inverted yield curves were used to tame inflation during times of war. The country's 20-year bond yield inverted during the Russo-Ukrainian War. Sri Lanka's bond market also experienced an inverted yield curve in 2022, as the country struggled with an economic crisis.

Brazil's bond market saw an inverted yield curve starting in August 2014, as part of the country's economic crisis. Iceland's bond market inhaled an inverted yield curve in 2008, during the country's financial crisis.

Here's a list of some countries outside the US that have experienced inverted yield curves:

Japan's bond market has also seen its fair share of inverted yield curves, with a notable instance in 1990. The country's zero-interest-rate policy started in 1999, and negative interest rates began in 2014.

The inverted yield curve has been a topic of interest for decades, and its predictive powers have been debated by many. The 10-year to two-year Treasury spread has been a generally reliable recession indicator since the mid-1960s.

The first recorded instance of an inverted yield curve was in 1986, when Canadian economist Campbell Harvey coined the term in his PhD thesis at the University of Chicago. Harvey's work laid the foundation for understanding the concept.

In 1998, the 10-year/two-year spread briefly inverted after the Russian debt default, but the Federal Reserve's quick interest rate cuts helped avert a U.S. recession. This was a rare instance where the yield curve inversion didn't lead to a recession.

The 2006 yield curve inversion was a notable example, as long-term Treasury bonds outperformed stocks during 2007. The Great Recession began in December 2007, just a year after the yield curve inversion.

The 2019 yield curve inversion was a more recent example, where the spread briefly went negative on August 28. This inversion preceded the two-month recession in February and March 2020, caused by the COVID-19 pandemic.

Interest rate risk is a key concept to understand when dealing with an inverted yield curve. It occurs when longer-term bonds are more sensitive to changes in market rates than shorter-term bonds.

The price sensitivity of a bond to changes in current rates is larger for longer maturity bonds than for shorter maturity bonds. This means that even though you're not technically locked into a bond, you face more risk for longer maturities.

An upward sloping yield curve is considered "normal" because it reflects the preference for shorter maturities due to interest rate risk. This is why the yield on 10-year treasuries has been higher than 3-month T bills by an average of 1.6% between 1928 and now.

An inverted yield curve, on the other hand, is unusual and reflects bond investors' expectations for a decline in longer-term interest rates. This view is typically associated with recessions.

Here are some key takeaways from the yield curve: