What is an Inverted Yield Curve and Why Should You Care?


James Bernard, CFA, Managing Director, Fixed Income

In recent months, a favorite topic of the financial press has been speculating when and if the U.S. Government bond yield curve will invert. An inverted yield curve occurs when shorter maturity bonds yield more than longer maturity bonds. This inversion typically occurs late in an economic cycle and can foreshadow a recessionary environment in no small part due to what an inversion does to credit availability given most banks borrow short (deposits) and lend long (mortgages etc.). With our current economic cycle entering its 9th year, it is worth considering the shape of the yield curve and the role it could play over the remainder of the current cycle.

In terms of the current yield curve, the 2-year U.S. Treasury note, a proxy for the short end of the curve, currently yields 2.6% while longer maturities, as measured by the 10-year U.S. Treasury bond, yield 2.85%, a spread of approximately 25 basis points. Additionally, overnight fund rates, as measured by Fed Funds, yield 1.9%, 70 basis points below the two-year rate (see below chart). Observing current action in the Fed Funds futures market, it seems likely that the Fed will increase overnight rates at least two more times before year-end 2018. If so, overnight funds should be yielding in the range of 2.4% sometime later this year. If we assume the difference in yields between overnight funds and 2-year government notes remains about 70 basis points, this implies that 2-year government notes should yield close to 3.1% by year-end 2018.

Fed Funds Rates

Source: Bloomberg

The more difficult data point to forecast is where longer-term rates will be later this year. If the 10-year U.S. Treasury bond yield remains near its current level of 2.85%, we would have a modestly inverted yield curve by year-end 2018. Even if the 10-year U.S. Treasury yield increases modestly to just over 3%, we still may be inverted. Typically, longer-term yields trade off inflation numbers or inflationary expectations, and inflation has increased in recent months from 2.1% (CPI year over year) to 2.9%. If this trend towards higher inflation continues, longer term rates are likely to increase towards 3.5% or higher and therefore the yield curve, while remaining flat, may not actually invert this year or even next year.

While it is our view that the domestic economy should remain fairly robust for the remainder of the year and into 2019, which would result in additional Fed rate increases, the future course of inflation remains very uncertain. Once we reach 2020 and beyond with higher rates in place, and both tax cuts and deregulation fully digested, one could surmise that some eventual form of economic slowdown or even a recession could occur. Only time will tell if a lack of inflation will lead to an inverted yield curve during the current rate-tightening cycle and whether that, in and of itself, will be the cause of the next recession.

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