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Analytics, 31 March 2022

Inversion of the US treasury yield curve

The U.S Treasury yield curve inverted on Tuesday for the first time since 2019, as investors priced in an aggressive rate-hiking plan by the Federal Reserve as it attempts to bring inflation down from 40-year highs.

The two-year versus 10-year yield on a U.S. Treasury bond is generally the most-watched by economists. That curve hasn’t yet inverted, but another part of the market did on Monday.

Historically, an “inverted yield curve” in the bond market has occurred before U.S. recessions. The situation happens when short-term bond yields exceed those of longer-term bonds, meaning that investors are worried about the economy’s long-term prospects.

Aside from signals it may flash on the economy, the shape of the yield curve has ramifications for consumers and businesses. While rate increases can be a weapon against inflation, they can also slow economic growth by increasing the cost of borrowing for everything from mortgages to car loans.

What’s an inverted yield curve?

When the bond market is healthy, yields are higher for bonds with a longer time to maturity. For example, a 10-year Treasury bond would carry a higher yield (or, interest rate) than a one-year Treasury.

In other words, short-term yields are lower than long-term yields. Investors expect a bigger reward for lending their money for a longer time, giving the “yield curve” an upward sloping shape. When the curve inverts, short-term bonds pay a higher yield than long-term ones. It’s a distortion in the market.

Why is it a warning sign for the market?

The U.S. Treasury finances federal government budget obligations by issuing various forms of debt. The $23 trillion Treasury market includes Treasury bills with maturities from one month out to one year, notes from two years to 10 years, as well as 20- and 30-year bonds.

The yield curve plots the yield of all Treasury securities. Typically, the curve slopes upwards because investors expect more compensation for taking on the risk that rising inflation will lower the expected return from owning longer-dated bonds. That means a 10-year note typically yields more than a two-year note because it has a longer duration. Yields move inversely to prices.

A steepening curve typically signals expectations of stronger economic activity, higher inflation, and higher interest rates. A flattening curve can mean the opposite: investors expect rate hikes in the near term and have lost confidence in the economy’s growth outlook.

Aside from signals it may flash on the economy, the shape of the yield curve has ramifications for consumers and business. While rate increases can be a weapon against inflation, they can also slow economic growth by increasing the cost of borrowing for everything from mortgages to car loans. When short-term rates increase, U.S. banks tend to raise their benchmark rates for a wide range of consumer and commercial loans, including small business loans and credit cards, making borrowing more expensive for consumers. Mortgage rates also rise.

When the yield curve steepens, banks are able to borrow money at lower interest rates and lend at higher interest rates. Conversely, when the curve is flatter, they find their margins squeezed, which may deter lending.

Is a recession coming?

An inversion in the yield curve doesn’t necessarily trigger a recession. Instead, it suggests bond investors are worried about the economy’s long-term prospects. Investors pay most attention to the spread between the two-year U.S. Treasury and the 10-year U.S. Treasury. That curve isn’t yet flashing a warning sign. However, the five-year and 30-year U.S. Treasury yields inverted on Monday, the first time since 2006, before the Great Recession.

Data suggests a recession is unlikely to be imminent if one materializes. It took 17 months after the bond-market inversion for a downturn to start on average. There was one false alarm, in 1998. There was also an inversion right before the Covid-19 pandemic, which may also be considered a false alarm, since bond investors couldn’t have predicted that health crisis.

Still, a recession isn’t a foregone conclusion. It’s possible the Federal Reserve will calibrate its interest-rate policy appropriately and achieve its goal of a “soft landing,” whereby it reduces inflation and doesn’t cause an economic contraction. The war in Ukraine has complicated the picture, fueling a surge in prices for commodities like oil and food.

Many economists have adjusted their economic forecasts, though. J.P. Morgan puts the odds of recession at roughly 30% to 35%, which is elevated from the historical average of about 15%.

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