Inverted Yield Curve? Is it Bad?

Inverted Yield Curve? Is it Bad?

Meaning of an inverted yield curve – it’s not what you think– unless you believe in it

Everyone starts making a fuss when the yield curve inverts.

You can also watch the YouTube video here:

What is an inverted yield curve?

Simply put, an inverted yield curve is when shorter duration U.S. Government Treasuries (typically the 3-month to 2-year note) have a higher interest rate than longer duration U.S. Government Treasuries (typically the10-year bond).

A normal yield curve has yields on longer duration Treasuries at a higher yield than shorter duration Treasuries. This is normal because the longer the duration, the higher the risk of the Treasury. Therefore, longer duration Treasuries should have higher yields because they carry higher risk.

The graphs look something like this:

Graph showing normal (blue) and inverted (gray) yield curves. Duration is the length of the Treasury (loan) to the Government

How is this even possible?

The Federal Reserve Board controls short-term interest rates, while the market demand determines the yields on longer-term Treasuries.

When the Federal Reserve Board starts to believe that inflation is becoming a problem, they try to slow things down by raising short-term interest rates. If the market doesn’t follow suit by selling longer-duration bonds, causing the longer duration yields to rise, the yield curve becomes inverted.

The chart below shows the “common wisdom” belief about inverted yield curves.

Common wisdom isn’t always wise.

The Fed even promulgates this myth that an inverted yield curve portends bad things are about to happen

Is an inverted yield curve necessarily bad?

The answer is NO and let me explain why.

All economic cycles will ultimately go through four phases:

1.      Expansion

2.      Peak

3.      Contraction

4.      Trough

What really matters to you and me is the difference between the Peak and the Trough.

If this difference is small, it’s likely not going to have much of an impact on our lives, but if the difference is large, the impact could be large.

How can we measure this?

If we look at a graph of the change in Real Gross Domestic Product and the change in the Unemployment Rate, this will give us a clue. You can see in the graph below that the when the red line (Real GDP) dips, it is often accompanied by an increase in the blue line (Unemployment Rate).

I would argue that the threat caused by unemployment doesn’t become severe until the unemployment rate approaches 10% as it did in the early and late 1950s, mid 1970s, early 1980s, 2008-09, and early 2020. That’s 5 times out of 12 or 41% of the time we had a more severe recession.

Now you might argue that the bubble burst from 2000to 2003 was a severe pullback, but it really affected the stocks way more than the companies with real revenue and earnings.

In addition, the unemployment rate in 2000 to 2003 didn’t approach anywhere near 10%, and the housing markets performed very well through this period.

Less than half of the times the yield curve inverted there was a severe recession

The Self-fulfilling Problem

If enough people with control of a large enough amount of people resources and money believe that an inverted yield curve means trouble, then the economy and the markets can be made much worse by that belief.

Here is how a belief that an inverted yield curve is bad can make things worse:

1.      Companies reduce or even stop capital spending and stop hiring or even start laying off workers

2.      Investors sell risk assets and buy safety assets causing the equity markets to fall (which can lead to #3 below)

3.      Falling equity markets cause investors to feel less wealthy so they curtail investments and spending

The end result: The actions taken by corporations and individuals can become a self-fulfilling prophecy causing the economy to fall into a deeper recession than is warranted.

The Bottom Line

It’s normal for the yield curve to invert between economic downturns, and an inverted yield curve doesn’t necessarily mean bad things are about to happen. In fact, bad things happen less than half of the time, so let’s not get ahead of reality and make it worse by believing an inverted yield curve is a harbinger of bad things to come.

Also keep in mind that before 2007, the yield on the 10-year Treasury bond was in a range of 3% to 8% - well above the current yield of 2.7% and the economy performed just fine through most of this period.

Graph showing the yield on the 10-Year U.S. Government Treasury Bond since 1991
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