The Inverted Yield Curve
The history behind inverted yield curves, monetary policy, and US recessions.
Strategy at Repool, ex-Goldman Sachs Trader, Wharton MBA
The Inverted Yield Curve
Before we talk about the phenomenon of the inverted yield curve, let’s talk about bonds.
The bond market is massive, it’s bigger than the stock market and much, much older.
The first loan on record dates all the way back to 2,400 BC in Mesopotamia, meanwhile the modern stock market didn’t emerge until the Tulip Market in the early 1600s–what a late bloomer.
Debt is the backbone for the majority of the world’s financing and asset valuations. Yet among the retail investing community, bonds are not nearly as well understood nor as well followed as equities are.
We’re here to change that, so buckle up and get ready to learn.
What is the Yield Curve?
Starting from brass tacks, let’s talk about the yield curve.
Simply put, the yield curve is a graph that plots the annual returns of similar bonds on one axis versus the maturities of those bonds on the other.
The shape of the curve is its slope, or the difference in yield between various bond maturities. The slope of the yield curve can tell us a lot about how investors feel about the domestic economy and world at large, and therefore is a key macro indicator to watch.
Usually, the yield curve is upward sloping as longer dated securities are inherently riskier, and people demand higher yields for lending their money out for a longer period of time. This is the time value of money in action: if I lend Joe $10,000 for 1 month and Sally $10,000 for 10 years, I’d naturally ask Sally to pay a higher rate of interest than Joe.
We’re going to focus on the United States Treasury yield curve, which is often discussed in the news-cycle. This is a collection of the most recently issued US treasury bonds and their current yields. If the US Treasury issues bonds maturing in 1 year, 2 years, 3 years, 5 years, etc., then the US Treasury yield curve would be a line graph plotting all of these maturities and their yields, showing the relationship between them.
There are several ways to calculate a yield curve, but you’ll most commonly see a “nominal par yield curve”. Here, “nominal” means the yields are not adjusted for inflation, and you can think of “par yield” as the coupon a new bond issued at par (the standard $1,000 face value that bonds are typically issued at) would have to pay in order to match the returns of existing bonds. Said another way, the “par yield” is the coupon the issuer must pay on a new bond for the investor to be indifferent between the new bond and the old bond.
Let’s go back to the treasury yield curve.
If the 2 year treasury is yielding 2.60% and the 10 year treasury is yielding 2.90%, then this curve is 0.30% steep or the 10 year yield minus the 2 year yield. The shorthand way to reference this formula is “2s10s” and you can apply this naming convention to any two maturities. Ie. 3s5s would be the 5 year treasury yield minus the 3 year treasury yield. So if 2s10s expands from 0.30% to 0.50% then we say 2s10s has steepened; conversely, if the basis collapses from 0.30% to 0.10%, then 2s10s has flattened, all of this can be easily visualized as a steeper and flatter line.
Earlier this month, we witnessed the phenomenon of an inverted yield curve. The difference between 2 year and 10 year treasury yields was briefly negative, producing a “kink” in the curve. In short, you could earn a higher return from buying a 2 year treasury note than from buying a 10 year treasury note.
In the chart below, you can see that a year ago the yield curve was clearly upward sloping and “normal”. Then, on April 1st, the 10 year treasury yield dips below the 2 year treasury yield, creating this inversion we just described. Even today, while 2s10s have un-inverted, the yield curve as a whole is much flatter than it was last year.
Why Should I Care about an Inverted Yield Curve?
Well, an inverted 2s10s curve is often cited as a leading indicator of an oncoming recession. Oh boy.
You can see from the graph below that while all National Bureau of Economic Research (NBER) designated recessions have been preceded by a 2s10s inversion, not all 2s10s inversions have been followed by a recession.
As with any financial instrument, the price of a security reflects the market’s expectations of future events, which are forward looking and probabilistic. By extension, an inverted yield curve doesn’t actually trigger a recession; instead, it reflects the aggregate market view that one could be near.
Historically, 2s10s have demonstrated statistically significant predictive power. This correlation means that it’s very unlikely to be merely coincidental that inversions precede recessions, and suggests that the market as a whole is fairly apt at foreseeing recessions.
What is the Link Between an Inverted Yield Curve and a Recession?
Recessions occur when real growth slows in the economy. A slowdown in growth can be policy induced through tighter financial conditions (e.g. hiking the Federal Funds Rate) and/or through exogenous factors (e.g. the COVID-19 pandemic, trade wars, supply chain shocks, commodity price volatility, etc.).
Generally, as investors expect a growth slowdown, the difference between short and long-term treasury yields collapses in anticipation of more accommodative monetary policy to come, vis-a-vis the Fed cutting the Federal Funds rate. Lower interest rates translate into less incentive to save and more incentive to invest and/or spend, thus stimulating the economy.
Once easier policy is implemented or just priced into market expectations, the entire yield curve simultaneously shifts downward to reflect a lower rates environment, and re-steepens into an upward sloping shape.
We call this a bull steepening curve.
Bullish, because all yields are rallying lower. Note that price and yield have an inverse relationship: as yields move lower, bond dollar prices move higher; therefore, lower yields mean that rates are rallying. Steeper, because short maturity treasuries rally harder than long maturity treasuries as investors begin to demand higher yields from longer maturity treasuries to compensate for the opportunity cost of tying up their capital during a market upswing.
Why do we Look at 2s10s Specifically?
Not all parts of the yield curve have equal predictive power, and 2s10s actually aren’t as “clean” or “sharp” of an indicator as some of their curve mates. There are a number of factors contributing to the noise in 2s10s.
In response to the 2008 Financial Crisis and again in 2019 during the US-China trade war, the Federal Reserve bought unprecedented amounts of government debt and hammered yields to historically low levels. Specifically, the Fed began to buy more long-end bonds, which are far more scarce than front-end bonds. Many point to this financial stimulus as the main reason behind an “artificially” flattened yield curve.
There are other explanations as to why 2s10s has persistently been so flat of late, such as the zero lower bound Fed Funds rate, the view that the recent spike in inflation is transitory, or the idea that the Fed won’t be able to hike too aggressively before decelerating growth compels them to stop. We’ll dig deeper into these concepts next time in The Federal Reserve article.
More philosophically, some argue that the popularity of watching 2s10s has triggered the Heisenberg Effect, a principle stating that the very act of observing a phenomenon alters the behavior of the phenomenon. Most likely, the complete answer is a little bit of column A and a little bit of column B.
But there’s another, stronger market signal you should know about.
Meet the Near-Term Forward Spread
The near-term forward spread is the difference between the current 3 month Treasury bill yield and the 3 month Treasury bill yield in 18 months, or the “forward rate”.
In 2018, Engstrom, Eric, and Steve Sharpe published their research testing the predictive power of various parts of the yield curve. As a single indicator, the near-term forward spread had the greatest explanatory power out of the most commonly referenced recessionary indicators. Including 2s10s, 3mo10yr, and a well-known survey of professional economic forecasters–known conveniently as the Survey of Professional Forecasters.
What they found was that the near-term forward spread provided a much “cleaner” indicator of a future recession, lacking the idiosyncrasies of longer dated treasuries, and was a much “sharper” signal with steeper inversions. You can see the relative reactivity of the near-term forward spread versus 2s10s in the graph below.
Furthermore, the near-term forward spread itself is far more congruent with the economic reporting calendar as GDP and many other economic data are reported on a quarterly basis. In fact, change in GDP is usually one of the most important factors in the NBER’s determination of a recession.
What is the Near-Term Forward Spread Telling us Now?
Let’s drill down on the previous graph to a YTD chart between the near-term forward spread and 2s10s. Here, you can see that the near-term forward spread has been in positive territory this year so far, indicating little concern from the market of a recession in the next 1–2 years. In the past month, 2s10s have also re-steepened.
Should we be worried about a Recession at all?
For now, a recession looks unlikely and is not our base case for the next 1–2 years. Our preferred leading indicator, the near-term forward spread, has been persistently positive and even the inversion in 2s10s was extremely brief–not exactly panic worthy signals.
However, the overall probability of a recession has ticked higher in response to exogenous macro shocks which inherently influence the picture at home. Broader economic data reveal a tight labor market and so-so growth prospects, but a persistently high level of inflation. Luckily, the Fed has made combating high inflation their top priority and the strength of the labor market indicates that domestic growth should be able to withstand tighter financial conditions.
As with building any market thesis, we always step back and take in the full picture. For the time being, we’re monitoring the near-term forward spread as a potent leading indicator of a recession, but alongside many other robust economic data points as well.
Get to know the biggest influencer of the yield curve, the Federal Reserve.
Graeber, D. (2011). Debt: The first 5,000 years. Brooklyn, N.Y: Melville House.
Engstrom, Eric, and Steve Sharpe (2018). “(Don’t Fear) The Yield Curve,” FEDS Notes. Washington: Board of Governors of the Federal Reserve System, June 28, 2018, https://doi.org/10.17016/2380-7172.2212.
Engstrom, Eric C., and Steven A. Sharpe (2022). “(Don’t Fear) The Yield Curve, Reprise,” FEDS Notes. Washington: Board of Governors of the Federal Reserve System, March 25, 2022, https://doi.org/10.17016/2380-7172.3099.