The Yield Curve is Inverted. What Does That Mean?

November 2, 2022 580 view(s)

The yield curve is inverted. The 3-month T-bill pays more than the 10-year Treasury Bond. Financial pundits say an inverted yield curve usually indicates a recession. Most people that study finance know what they are saying, but it probably sounds like broken Sanskrit to laypeople. This article will explain the yield and inverted curves and why they matter.

What Is the Yield Curve?

Yield curves plot the returns of bonds with different maturity dates. Longer maturity date bonds should pay a higher rate of return than shorter-term bonds. A standard yield curve will go up and to the right. See the graphic for an example.

What Is an Inverted Yield Curve?

An inverted yield curve is an abnormal graph formation where shorter-term bonds pay more than longer-term bonds. The graph will go down and to the right. See the graphic for an example.

Why Do They Matter?

Usually, the longer a bond or any loan has for the borrower to pay it back, the higher the risk of default. For this reason, longer-term bonds pay higher interest rates to compensate the lender for their risk. Investors expect long-term interest rates to decline when shorter-term bonds pay more than longer-duration bonds. Higher short-term interest rates indicate pessimism about increased short-term risks in the market.

What Are the Indicators to Look At?

Usually, investors compare the 2-year to the 10-year yields. Comparing the two yields has been an accurate way of predicting recessions. The 2/10 yield inversion has accurately predicted 12 of the last 14 recessions, including the two “less than trend growth” quarters of 2022. However, when the yield curve inverted earlier this year, Chairman Powell said the Fed looked at the 3-month to the 10-year yield curve to predict recessions and what the relationship will look like in 18 months. The 3-month to 10-year is now inverted with the 3-month at 4.22% and the 10-year at 4.1%. Interpreting Powell's words, interest rates will stay high until the end of 2023 or early 2024 before the Fed pivot to lower interest rates.

Why Would an Investor Choose a Long-Term Bond With a Lower Yield?

High inflation is the most common culprit creating an inverted yield curve, usually leading to interest rates rising quickly. The thought is that eventually, demand will be destroyed, and inflation will change to deflation. Interest rates will return to normal levels. When deflation is the reality, any nominally positive return will be better than the alternative of lower or negative interest rate yields. At the time of writing, the 10-year yield is 4.1%. Suppose investors think deflation will be a reality before ten years. In that case, a 4.1% yield will be more attractive than the three-month 4.22% when inflation is still climbing. The push-pull of supply and demand and rising interest rates will make short-term yields grow, and long-duration yields decline. Is that as clear as mud?

What Is Better, Gold or 30-Year Treasuries?

Looking back 30 years to 1992, the average return on gold has been 6.35%. Some years were positive, and some years negative, but the average is 6.35%. The current rate on a 30-year treasury is 4.22%.

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