INVESTING | The Inverted Yield Curve
The yield curve is a graph with Treasury bond interest rates as the Y axis, and duration, or time to maturity, as the X axis. Normally, interest rates, or yields, increase with longer duration because longer duration bonds have more exposure to inflation. A normal yield curve has a steady upward slope.
In some instances, market forces invert the yield curve when interest rates either stay constant or drop as duration increases. It is difficult to isolate the exact reason market forces would invert the yield curve, but two possible options include:
Investors are more concerned about low, or negative, growth than they are about long-term inflation.
Investors anticipate the Fed will lower short-term interest rates to help stimulate the market.
Both of these scenarios are bearish. Investors flock to longer-term bonds, which increases their market price, and therefore lowers the yield¹. The end result is an inverted yield curve.
Inverted yield curves are an important forecasting tool because invested yield curves have accurately predicted economic downturns in the past.
The yield curve is one of many indicators that impact both strategic and tactical investment decisions. Fortunately, inverted yield curves are an early indicator. The last time we had a deeper inversion than we have today was 2006, and the S&P 500 moved up 17% after the 2006 inversion but before the 2007 peak.
We expect to have a pullback from current highs; we do not know either how much of a pullback, or when. Instead, we will continue to track indicators like the yield curve and manage our strategic investment allocation as appropriate.
¹ This is counter-intuitive, but if a bond has a stated interest rate that is based on the bonds original value, when that bond’s market price increases, the yield will decrease proportionately. For example: a $10,000 bond with a 5% yield will pay $500 per year. If the bond trades at $9,500, then the annual $500 payment is 5.3% of the current market value. Similarly, if the bond trades for $10,500, then the annual $500 is 4.8% of the current market value.