The Crystal Ball of Investing: What a Yield Curve Inversion Means for Investors

The Crystal Ball of Investing: What a Yield Curve Inversion Means for Investors

The bond market has predicted recessions since the 1950s. Here's why it's important to understand the bond yield curve.

The Crystal Ball of Investing: What a Yield Curve Inversion Means for Investors
Moriah Costa

Published Aug 26, 2022Updated Aug 31, 2022

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Brainstorm

Market Analisys

Market Analisys

Bonds

Bonds

There’s no crystal ball when it comes to investing, but a yield curve inversion might be the best way for investors to tell the future.

While fortune tellers can’t tell us exactly when a recession will occur, the inverted yield curve acts as a type of predictive tool for investors.

The condition of bond markets can be a warning signal to investors of a possible upcoming recession. While not 100% accurate, movements in the treasury bond market are one of the most reliable leading indicators for predicting economic conditions such as an upcoming recession. When interest rates on short-term government borrowing exceed the interest rate on long-term borrowing, this is known as an inversion of the bond yield curve.

And when the treasury yield curve inverts, many investors take it as a sign of a troubled economy and stock market.

What is a yield curve?

Many governments issue bonds, but bonds from the U.S. are considered one of the safest bets due to the stability of the government and economy—that's why so many investors hold bond ETFs in their portfolios. And because the U.S. dollar is a key player in the global financial world, the U.S. treasury yield curve is often used as a gauge for the future of the world’s largest economy.

A yield curve is a graph showing interest rates on government bonds as a function of their maturity date. How long it takes for a bond to mature varies from just one day to a month or even decades. The most common bonds are 3-month, 2-year, 10-year, and 30-year treasury notes.

Yield curves usually slope upwards to indicate that investors get a higher rate of return for lending money to the government for longer. This is referred to as a normal yield curve. Short-term yields tend to fluctuate based on Federal Reserve bank policies like interest rates, while yields on long-term treasury bonds vary based on whether or not investors think there'll be economic growth over the medium to long term.

When the economy slows down, the yield on longer bonds, such as 10- and 30-year bonds, tend to get closer to those of shorter bonds, such as 3-month and 2-year bonds. This is because investors think that there’ll be lower inflation in the long run and a lesser need for the central bank to increase the federal funds rate.

When this happens, it flattens the yield curve and can be a precursor to an inverted yield curve. When the yield curve steepens, it’s a bit like how a roller coaster slows down at the top before picking up speed and plunging.

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Source: giphy.com

What is a yield curve inversion?

An inverted yield curve occurs when there's more demand for short-term bonds than for longer-term bonds among investors, thus higher yields on short-term bonds. This generally happens because investors believe economic growth will slow in the near term and are instead parking their money in safer assets like bonds, which are often one of the best assets to invest in during a recession.

As demand for longer-term bonds increases, so does the price. This is because there’s an inverse relationship between bond prices and yields. When bond prices rise, the yield rate falls, and vice versa.

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So when investors shift their money from short-term to long-term bonds, the price of short-term bonds falls and the yield rises, causing an inverted yield curve. This can trigger stock market downturns as investor confidence weakens and may even prompt the Fed to hike interest rates.

For example, let’s assume the economy is doing well and the 3-month bond rate is at 3.5% while the 10-year rate is at 5%. This would be a normal yield curve. Now let’s say some investors think the economy is going to slow down and weaken in the near term and that the Federal Reserve will lower the interest rate to stimulate economic growth.

In that case, investors might decide to invest in more long-term bonds to lock in those good interest rates. When a lot of investors start doing this, then the rates of the long-term bonds start to fall and yield spreads increase. And in the case of an inverted yield curve, long-term bond rates fall below short-term bond rates.

An inverted yield curve is rare and doesn’t happen very often as periods of economic expansion have lengthened. So, when an inversion does occur, there are generally a lot of implications for both investors consumers since it's a reliable indicator of a recession according to many economists.

Are inverted yield curves a recession indicator?

While fortune tellers can’t tell us exactly when a recession will occur, the inverted yield curve acts as a type of predictive tool for investors. An inverted yield curve is considered a possible indicator of a recession because it consistently occurs between seven to 24 months before a recession.

In fact, for the past half-century, an inverted yield curve has preceded every recession. In a way, it’s a barometer for investor sentiment. A rise in demand for long-term treasuries signals risk aversion among investors, indicating they’re concerned about a pending economic recession.

Most investors on Wall Street look at the relationship between the 2-year and 10-year yield, but economists also look at the yield spreads between 3-month bills and 10-year notes.

Crystal ball

Crystal ball

Do you think there’ll be another recession?

Historical examples of yield curve inversions

The last time yield curves inverted was in July 2022, which is one reason investors are seeking inflation hedges and economists are concerned about a potential recession. The inversion of the 2- and 10-year bond yield curve was mainly due to concerns over inflationary pressures, Russia’s invasion of Ukraine, and soaring energy costs that resulted from it.

The historical precedence of inverted yield curves predicting a recession is the most prominent reason why investors are worried. The yield curve inverted in 2019 and, in early 2020, the pandemic caused a recession, although it’s also likely the economy was already showing signs of slowing growth.

 An inverted yield curve also occurred in late 2005 when the Federal Reserve raised short-term interest rates in response to an overheating housing market. This predated the start of the Great Recession of 2007, after inverting in late 2005 until mid-2007.

And the dot com recession was also predicted by an inverted curve in late 2000 when the technology bubble burst, triggering an 8-month-long recession in March 2001.

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Chart of 10-year and 1-year treasuries yield spread compared to 10-year and 3-month treasuries yield spread with economic recessions indicated from 1953 to present.

Source: stlouisfed.org 

The track record of inverted curves is why economists and investors take note when the curve inverts again. However, it’s not always accurate. For example, the yield curve inverted in 1965, but there was no recession until 1970.

What does an inverted yield curve mean for investors?

Recessions are a normal part of the economic cycle, but that doesn’t mean finding ways to keep your money safe from a possible market downturn won't hurt.

Following the yield curve can help investors know when a recession is imminent and do what they can to protect their portfolio, such as by investing in alternative assets like art. An inverted yield curve is also a warning for equity investors as profit margins for companies like banks (who borrow in the short-term and lend in the long-term) tend to fall.

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Keep in mind that there’s been a lag between inverted yield curves and recessions in the past, so the economy won’t necessarily heat up overnight. That’s also the biggest criticism of yield curve inversions. The crystal ball of investing paints a murky image—the inversion only tells us that a recession will happen, but not when it'll happen. And while it’s been reliable in the past, it’s not a perfect system.

Plus, just because there is an inverted yield curve doesn’t mean you should start selling off your stocks. Instead, it helps to look at top-performing asset classes that do well as a recession-resistant allocation in your portfolio, consider rebalancing your portfolio, and assess how a higher key interest rate will impact your situation in the near future.