Parts of the Yield Curve Just Inverted

Parts of the bond market went topsy-turvy on Friday.

Typically bond yields have an upward slope when maturities are charted in order of length left to right, meaning that longer-dated bonds have yields above shorter-dated bonds. This is called the yield curve.

On Friday, however, this rule of thumb was broken when the yield on the ten-year Treasury bond dropped below the yield on the seven-year Treasury.  And the three-year bond’s yield rose above the five year. This is described as an inversion of the yield curve.

The yield curve is a way to show the difference in compensation investors get depending on how long a bond takes to mature. Most of the time, the curve slopes upward because investors usually want to be paid more in exchange for locking their money up for longer.

But at times the relationship can flip, or invert, with shorter-term bonds yielding more than longer-term bonds. And that’s what happened on Friday.

The more closely watched parts of the yield curve, the difference between two-year and 10-year bonds, flattened to just twenty basis points but remained uninverted. (A basis point is one-hundreth of a percent.)

An inversion of the two and 10 year proceeded ever recession since the 1970s, including the brief recession brought on by the pandemic lockdowns in 2020. Economists also believe the difference between the three-month yield and the 10-year yield has predictive power.

By midday, the ten-year, five-year, and three-year were all trading right around a yield of 2.15 percent. The seven-year was at 2.18 percent and the two-year at 1.953 percent. At some points, the three-year yield was higher than the 10-year yield.

The yield curve reflects market expectations about future monetary policy actions from the Federal Reserve, the expected path of inflation, the risks faced by the economy, and uncertainty about those outcomes.  Since longer-term bond yields more or less reflect the expected path of future short-term rates, an inversion can be an indicator that investors think the Federal Reserve will have to cut its short-term interest rate target because of slumping economic growth or an approaching recession.

An inverted yield curve does not always foreshadow a recession, however. Intraday inversions that quickly correct to the normal relationship have often been misleading signals.

The yield curve may also have lost some of its predictive power. Very large budget deficits have increased the amount of bonds the government has issued. The government’s choices about which bonds to sell could cause an over-supply or under-supply in some parts of the yield curve, which in turn could invert the curve.

The Federal Reserve’s actions as it shrinks its balance sheet, inflated from years of bond buying under the central bank’s quantitative easing program, may also be putting pressure on the curve. This is largely an unprecedented event so its effects are hard to predict and likely will not be known for years.