Inverted Yield Curve

Santa may have been a hit for the kids this year, but he forgot to leave the Santa Claus rally under the tree. The culprit this time may have been the specter of an inverted yield curve.

An inverted yield curve occurs when shorter-term bonds yield more than longer-term bonds. That happened on the 20th of December when the 2-year Treasury briefly offered a fraction of a point higher yield than the 5-year Treasury. There was only a tiny 5 basis point (.005) positive spread between the 2-year and the 10-year Treasury.

Some market followers saw this as a warning of a recession to follow and responded by selling off the market. These investors interpreted an inverted curve as an indication that the economy will soon experience a slowdown, which causes future interest rates to give even lower yields. Before a slowdown, it is better to lock money into long-term investments at present prevailing yields (because future yields will be even lower).

And, as in all things economic, others saw this as simply a confluence of a number of factors bearing on interest rates, and not as a recession red flag.

Historically, a better predictor of a recession to come has been the yield spread between the three-month Treasury bill and the 10-year note as it more closely reflects the expectations of future fed policy and the shifting business cycle. As of the 29th, that spread remained above 50 basis points, as it has been for the better part of the past three months.

In a typical yield curve configuration, shorter maturity debt carries a lower interest rate than longer maturity debt. This yield curve represents a normal, growing economy where money is plentiful on the short end, allowing businesses to expand, the economy to grow, and longer-term bond investors to see more future risk in holding fixed-income securities. With this uncertainty, investors demand a higher return for the money they loan, leading to higher long-term interest rates.

A second type of a yield curve is essentially flat, with little spread between the interest paid on short-term and long-term debt. Faced with conflicting market signals, investors find it difficult to chart a course for the future. This commonly occurs during market transition times, as is the case today, with the Fed near the end of a tightening cycle. Here we see the impact of the mixed positions . some say bad times are coming, while others take more positive positions.

In times like these, more risk-adverse bond investors will do well to select bonds with lesser rather than more risk . i.e. higher credit quality.

Finally, the rarest of yield curves is an inverted curve. These inversions have historically preceded many, but not all, U.S. recessions. A recent example occurred in 2000 just before the stock market bubble burst. In this case, the demand for long-term bonds increased as stock market risk went up, and as the demand for bonds went up, yields fell below the price of short-term money.

A confirming indicator of bad times to come occurs when the credit spread between corporate and Treasury securities widen. Since corporate debt is more risky than U.S. issued debt, corporate paper carries a higher interest rate. When inflation rates are increasing (or the economy is contracting) this credit spread widens. This is because investors must be offered additional compensation (in the form of a higher coupon rate) for acquiring the higher risk associated with corporate bonds.

The opposite indication is given when interest rates are declining (or the economy is expanding) as the credit spread between U.S. and corporate debt begins to narrow. This lower interest rate is a stimulant for business as it allows them to borrow at lower rates to expand operations and production. As this expansion helps add jobs, consumer spending goes up, the economy grows, and gives all a truly Happy New Year.