What is an Inverted Yield Curve and does it predict a Recession?
AI's response in regular print | Beverly Hills, CFP®, Joe O'Boyle's in italics
Warren Buffett shared that only value of economic forecasts is to make fortune-tellers look good. Peter Lynch shared that if you spend 13 minutes a year on economic forecasts, you’ve wasted 10 minutes. So, with that as a fun backdrop…
“What is an inverted yield curve and does it predict a recession?”
If you loan money to someone, you expect them to pay you more interest if they are going to borrow your money for a longer period of time, while they should pay you less interest for a shorter term loan. When you buy a Treasury bond (bills, notes, bonds), you are loaning money to the U.S. government and you would expect the same—that shorter term bond yields would pay you less than longer term bond yields. However, there are times (like today’s environment), when shorter term bond yields actually pay more interest than longer term yields—this is called an inverted yield curve.
As of 8/4/23, the yield curve is inverted because a 3-month Treasury is paying 5.4%, which is more than a 2-year Treasury that is paying 4.8%, and more than a 10-year Treasury that is paying 4.1%.
5.4% - 3-month T-Bill Yield
4.8% - 2-year T-Note Yield
4.1% - 10-year T-Note Yield
Normally, longer-term bond yields should pay more than shorter-term bond yields to compensate investors for taking on the additional risk of holding a bond for a longer period. When this relationship flips, and shorter term rates are paying more than longer term rates, it creates an inversion. This inversion often indicates that investors expect long-term interest rates to decline, and historically, this phenomenon has been one of the most reliable indicators of an upcoming recession in the United States. For more than a year, the yield curve has been in an inverted state, with the inversion reaching levels not seen since the early 1980s. This has led economists and bond market investors to suspect that a recession is inevitable in the next year or two. But will that be the case this time?
Here's what this yield curve inversion may indicate:
Economic Indicator:
The inversion of the yield curve is an unusual situation that often prompts caution among investors and policymakers. An inverted yield curve has preceded every U.S. recession over the last 50 years. It reflects a lack of confidence in the future growth of the economy. Investors may be willing to accept lower yields on long-term bonds if they believe that the economy will slow down, or even contract, in the future. In a resulting flight to quality, they might see long-term government bonds as a safer place to park their money, despite the lower yields. An increased demand for long-term Treasury bonds often occurs when investors are seeking safe-haven assets.
However, it’s important to keep in mind that sometimes an inverted yield curve may not signal economic trouble but rather reflect temporary market dynamics, such as changes in supply and demand for various maturities, regulatory changes, or international capital flows.
Impact on Financial Sector:
An inverted yield curve can also put pressure on the financial sector, particularly banks that rely on borrowing short-term funds at lower interest rates and lending long-term at higher rates. The inversion can squeeze their profit margins and potentially lead to tighter credit conditions. This can have a broader impact on the availability of credit in the economy, possibly slowing down economic activity.
Caution:
While an inverted yield curve has been a historically accurate signal of a future recession, it is not foolproof. Other economic and financial indicators must be considered in the broader context. Timing, market dynamics, monetary policy, and global economic conditions can also play a significant role in interpreting what an inverted yield curve might mean at any given time.
Pramod Atluri is a bond portfolio manager for Capital Group. He has 24 years of industry experience (as of 12/31/2022). He holds an MBA from Harvard and a bachelor’s degree from the University of Chicago. He is a CFA charterholder.
According to Alturi, high inflation, which we haven’t seen since the 1980s, is the key determining factor today. Federal Reserve officials have made it clear that fighting inflation is their priority, and they appear to be achieving their goal of bringing prices back down to earth. Inflation fell to 3% in June 2023 from 9.1% a year ago, a remarkable decline in just 12 months.
That means Federal Reserve officials may be able to cut interest rates in the months ahead, not because they expect a recession, but because they are close to achieving their stated goal of 2% inflation.
“An inverted yield curve means the market is predicting that the federal funds rate will be higher today and lower tomorrow. That’s it,” Atluri adds. “The yield curve is not predicting an impending recession. It is predicting that inflation will be lower in the future and, therefore, the Fed will be able to end its rate-hiking cycle.”
“As a corollary, if inflation gets back to 2%, then an inverted yield curve will once again be a good predictor of declining economic growth and rising recession risk,” Atluri concludes.
Conclusion
An inverted yield curve has historically been considered a significant market signal and a warning sign of an upcoming recession. However, it is not infallible, and the timing, underlying causes, and context of each inversion must be carefully considered.
While this phenomenon continues to attract significant attention from investors, policymakers, and economists, it should be viewed as part of a broader toolkit for understanding economic trends and not relied upon solely. The complexities of the modern global economy require a multifaceted approach to forecasting, and the inverted yield curve, while important, is just one piece of the puzzle.
What did you think? How did AI do?
About OpenAI’s ChatGPT tool:
GPT (short for "Generative Pre-training Transformer") is a type of language model developed by OpenAI that is trained to generate human-like text. ChatGPT is specifically designed for generating text in a conversational style. It is a machine learning model and has been trained on large datasets of real-world conversations in order to learn the patterns and styles of human communication.
Joe O'Boyle is the founder and principal of O'Boyle Wealth Management, a full service financial planning and investment management firm, located in Beverly Hills, California. Joe O’Boyle was named to InvestmentNews 40 under 40 class of 2016, and has a catalog of financial planning and investing articles on Money.com & U.S. News. Disclosure information.