Inverted Yield Curve: what happens when it normalize?

Imagine a signal so powerful that it has accurately predicted every U.S. recession for the past 50 years.

A signal that savvy investors watch like hawks, knowing it can spell the difference between profit and peril.

Enter the inverted yield curve — a financial omen with the uncanny ability to foresee economic downturns.

But what exactly is it, and why should it matter to you?

First, what is a Yield Curve?

The yield curve is a graph that plots the interest rates of bonds of equal credit quality but differing maturity dates.

Typically, longer-term bonds have higher yields compared to short-term bonds, resulting in an upward-sloping curve. This reflects the higher risk and time preference associated with longer-term investments.

What does Inverted Yield Curve Mean?

An inverted yield curve occurs when short-term interest rates exceed long-term rates. This inversion is counterintuitive and often signals that investors expect future economic growth to slow down. Here’s why it’s significant:

Historical Predictor of Recessions: An inverted yield curve has preceded every U.S. recession since the 1950s. According to data from the Federal Reserve, the yield curve inverted before the recessions of 1970, 1974, 1980, 1990, 2001, and 2008. For instance:
- 1978: The yield curve inverted in August 1978, and the economy entered a recession in January 1980.
- 2006: The yield curve inverted in December 2005, and the Great Recession began in December 2007.
- 2019: The yield curve inverted in August 2019, preceding the brief recession caused by the COVID-19 pandemic in 2020.
Investor Sentiment: The inversion reflects a shift in investor sentiment. When investors seek the safety of long-term bonds, driving their yields down, it often indicates a lack of confidence in the near-term economic outlook.
Impact on Borrowing and Spending: Higher short-term rates can lead to increased borrowing costs for consumers and businesses. This can result in reduced spending and investment, further slowing economic growth.

Types of Yield Curve Inversions

While any yield curve inversion is notable, there are specific spreads that investors closely monitor.

10-Year Minus 2-Year US Treasury Spread

This spread compares the yields on 2-year vs. 10-year US Treasury bonds. It is one of the most commonly cited indicators of economic sentiment.
Historically, when the 2-year yield exceeds the 10-year yield, it has often preceded a recession by 12 to 18 months.

Current inversion started since July 2022. For the latest data on this spread, you can refer to the Federal Reserve Economic Data (FRED).

10-Year minus 3-month US Treasury Spread

This spread compares the yields on 3-month and 10-year US Treasury bonds. Research from the Federal Reserve has shown that this spread may be an even more reliable predictor of recessions.
According to studies, the 3-month vs. 10-year spread has inverted before each recession over the past 60 years, often with a lead time of about 12 months.

Current inversion started since October 2022. For the latest data on this spread, you can refer to the Federal Reserve Economic Data (FRED).

Why Does the Yield Curve Invert?

Several factors can lead to an inverted yield curve:

Federal Reserve Policy: Aggressive tightening of monetary policy by the Federal Reserve can push up short-term interest rates. If the market believes that such tightening will stifle economic growth, long-term rates may fall in anticipation of lower future inflation and economic activity.
Flight to Safety: In times of economic uncertainty, investors may flock to long-term government bonds, driving their prices up and yields down.
Economic Outlook: Expectations of a slowing economy or potential recession can cause the yield curve to invert as investors seek to lock in long-term yields.

What's next? Yield Curve Normalization

As we currently experience an inverted yield curve, it’s essential to consider what happens when the yield curve starts to normalize again.

Yield curve normalization typically occurs in the context of falling interest rates.
Both short-term and long-term interest rates decline, with short-term rates falling more significantly than long-term rates.

This environment is generally bullish for fixed income markets, as bond prices rise along the yield curve, enhancing total returns beyond just the coupon rates.

Equities May Struggle

While falling interest rates might initially seem favorable for equity valuations, historical data presents a more complex picture.

The reason equities tend to struggle during yield curve normalization lies in the broader economic implications.

Historically, an inverted yield curve has consistently preceded recessions.
As the economy weakens and inflation pressures decrease, the Federal Reserve usually responds by cutting interest rates.
However, these rate cuts often come too late to prevent a recession.

During recessions, corporate profits tend to fall sharply.

This decline is exacerbated by weakened demand, which reduces firms' pricing power and leads to shrinking revenues relative to costs.

This phenomenon can be observed in the historical pattern of US corporate profits as a percentage of GDP, where profits growth typically turns negative during recessions.

Current Market Dynamics

In 2023, despite falling S&P 500 profits, equity markets have rallied due to expectations of a pause in the Federal Reserve's rate-hiking cycle and hopes for a subsequent pivot to lower rates.

This optimism is fueled by solid US job growth and a remarkably low unemployment rate.

However, equity investors should be cautious.

The Fed's tight monetary policy could increase recession risks later in the year.

Conclusion

The inverted yield curve is a powerful economic signal that investors cannot afford to ignore.

While it’s not a definitive forecast of future market conditions, its historical accuracy as a recession indicator makes it a critical component of any investor’s toolkit.

By understanding its implications and adjusting your investment strategy accordingly, you can better navigate the complexities of the economic landscape.

Stay vigilant, stay informed, and stay inspired for better investment outcomes!