An inverted yield curve is when there is a higher yield investing in a shorter maturity bond than there is investing in a longer maturity bond. That is the case today. For example, as of February 16, 2023, the 2-year Treasury bond yields 4.64% and the 10-year Treasury bond yields 3.83%. Yield curve inversions are most often seen just prior to recessions. The Federal Reserve is typically increasing the Federal Funds Rate to slow the economy, pushing up shorter maturity rates. At the same time, longer maturity rates begin to price in slower growth and lower inflation, while also anticipating eventual rate reductions by the Federal Reserve in response to slower future economic growth. Here, we will answer two questions:
1.
In this environment, why would someone buy a 10YR bond that yields less than a 2YR bond? The simple answer is – reinvestment risk. Although you may be able to earn a higher rate of return for two years, once that bond matures you get your cash back and must reinvest. If interest rates fall, you may invest that cash at lower and lower yields every 2 years. This compares to locking in a yield at a longer maturity that, although lower today, may provide a better overall return if interest rates come down over your ten-year investment horizon.
2.
If inverted yield curves often signal a recession, why is the stock market rallying this year? It’s not unprecedented for stocks to rally significantly with an inverted yield curve. While history is no guarantee of future performance, the two largest S&P 500 increases with an inverted curve were both roughly +25% in 1979 and mid-2006 to mid-2007. If the current rally were to match these periods (+25%) it would bring the S&P 500 to approximately 4350. Obviously, in both prior examples, the rally eventually faded.
Lastly, using the chart below as a reference, it is typically the un-inversion of the yield curve that is associated with both recessions and additional market volatility. When the curve re-steepens, it is because the market is anticipating that the Federal Reserve will begin to cut interest rates (dropping the front-end of the curve) in response to an imminent contraction in economic activity.
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