Yield Curve Inversion

Yield Curve? What is that? Wait, more bond market content? I was told my precious digital assets were the future of finance, and nothing could affect them, especially not the boomer market. I have said it before, and I will repeat it: the bond market is the most essential asset class in the world, and when it speaks, you shut up and listen.

What is the Yield Curve?

The yield curve shows the interest rates that buyers of government debt demand to lend their money over various periods

Economic theory indicates that longer-dated bonds should yield more than shorter-dated bonds to compensate investors for duration risk: A lot can change in twenty years, but not so much in three months.

I have an excellent analogy for the confused readers where this needed to be clarified.

The yield curve is like a big rope the bulls and bears are pulling on. When the bulls are winning, the rope is steep and uphill because the economy is doing well, and people will lend money for extended periods. But when the bears gain the upper hand, the rope flattens out because people are nervous and unwilling to lend money for extended periods.

If the bears pull the rope down, so it's lower on the long end than on the short end, it's called a yield curve inversion.

What happens with yield curve inversion?

An inverted yield curve occurs when long-term interest rates are lower than short-term interest rates. This is considered unnatural because it goes against the expectation that long-term investments should have higher rates to compensate for the added risk.

In the real world, every day is a fantasy. There's no such thing. There are market cycles, and the yield curve does different things at different points in the cycle.

The differences between yields over different timeframes are seen as a proxy for other views of the market

2 Year/10 Year = Difference between expected interest rates in 2 years and longer-term economic growth expectations

They spread yield curve signals between two maturities. The downside is that there is no general agreement on which spread is the most reliable recession indicator.

2-Year/10-Year

Many investors use the spread between the yields on 10-year and two-year U.S. Treasury bonds as a yield curve proxy and a relatively reliable leading indicator of a recession in recent decades. Some Federal Reserve officials have argued that focusing on shorter-term maturities is more informative about the likelihood of a recession.

In the 2s10s curve, we are looking at the yield difference on holding US government debt of a two-year duration vs. ten years.

If the yield on holding debt of 2 years is higher than the yield on ten-year debt, this is known as curve inversion, as in the chart above where the difference is above 0%

Another simple analogy:

Imagine you're at a party, and someone offers to pay you less to perform longer. That sounds like a pretty lousy deal. That's what's happening with the yield curve.

Long-term interest rates are lower than short-term rates, which is the opposite of what we usually expect. The market says, "Hey, we'll give you less money if you're willing to wait a long time for it."

Interest rates tend to be able to increase in a good or rebounding growth environment, so if the bond market believes interest rates to be lower in 10 years versus in 2 years, it is essentially saying growth will be weaker, or at least not sustainable at current levels.

2-Year/10-Year History

The 10-year to two-year Treasury spread has been a reliable recession indicator since providing a false positive in the mid-1960s.

That hasn't stopped a long list of senior U.S. economic officials from discounting its predictive powers over the years.

In 1998, the 10-year/two-year spread briefly inverted after the Russian debt default. Quick interest rate cuts by the Federal Reserve helped avert a U.S. recession.
In 2006, the spread inverted for much of the year. Long-term Treasury bonds outperformed stocks during 2007. The Great Recession began in December 2007.

On Aug. 28, 2019, the 10-year/two-year spread briefly went negative. The U.S. economy suffered a two-month recession in February and March 2020 amid the outbreak of the COVID-19 pandemic, which could not have been a consideration embedded in bond prices six months earlier.

What does it mean for the future of finance?

An inverted yield curve can signify that investors are concerned about the economy's future health and are looking for safer investments. As a result, it can be a negative indicator for risk assets, such as stocks, cryptocurrencies, and even bonds, because it suggests that investor sentiment is shifting toward caution.

Does this mean Recession?

If you look back at recent history, the inversion of the yield curve always reverts to a recession, barring one data point. Now the one time a recession didn't occur is because the Fed started cutting interest rates. If the Fed starts being a bit softer on interest rates or we approach the terminal velocity, we could have a softer landing and no recession.

This is why there is so much chatter over inflation, whether it is peaking and where it could end up since interest rates change to affect inflation.

At this time, you shouldn't be a hero; you should save money to fight another day. The market is always there; there is no rush to buy the bottom. Patience will be rewarded!

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