- The yield curve shows the yield of bonds compared to their maturity lengths.
- Typical yield curves see long-term bonds have higher rates than short-term bonds.
- In recent months, the yield curve has inverted, with long-term bonds paying less than short-term bonds. This may be a predictor of a coming recession.
One important economic metric for many investors to keep an eye on is the 10-year Treasury yield. Treasury notes, bills, and bonds are debt instruments from the US government and are generally viewed as some of the safest investments out there. Investors use the 10-year Treasury yield as an indicator of investor confidence.
The Treasury sells these debt instruments at auction. The investor who accepts the lowest interest rate gets the bonds. When investors are confident in the market, rates will rise because fewer people want to buy bonds. When confidence is low, rates will drop as more people flock to bonds.
We’ll break down what’s been happening with the 10-year Treasury and the yield curve, and what it could mean for investors going forward.
What is the Yield Curve?
The interest rate of a bond is on the Y-axis and the maturity of a bond is on the X-axis. In most situations, the resulting picture will look like a curve where the line rises steadily before curving to get more flat near the end (see above).
This is because the longer a bond takes to mature, the higher the interest rate of that bond tends to be. This helps compensate investors for things like credit risk or inflation risk.
Investors often keep an eye on the yield curve for bonds like US government debt. Changes in the yield curve can forecast economic issues.
For example, an inverted yield curve, where rates start high and decrease as bond maturities get longer, is a powerful indicator. It shows that long-term investors believe that rates are on their way down. These investors bid down the interest rate on long-term bonds while trying to lock in current rates before they drop further.
Because lower interest rates tend to indicate economic slowdowns, inverted yield curves are often a sign of impending recession.
Typically, inverted yield curves are preceded by flat or humped curves, where rates are flat across maturities or medium-length bonds have rates higher than short- or long-term bonds. That makes these types of curves negative signs.
Conversely, steep yield curves where rates rise quickly as maturities get longer can be a sign of an upcoming economic expansion.
Does an Inverted Yield Curve cause a recession?
Inverted yield curves, on their own, don’t cause recessions. However, they can be indicators that the economy is on its way toward a recession.
Bond yields are set by investors and generally driven by how those investors view the economic outlook of the country. When the yield curve inverts, it shows that investors are not confident about the future.
So, while inverted yield curves aren’t the cause of a recession, they can be a herald of a recession caused by other factors.
What impacts bond yield?
There are a few things that impact the interest rate of bonds and that can result in changes to the yield curve.
As discussed, one is investor confidence. Treasuries are sold at auction, with the investor that bids the lowest interest rate winning the auction. As investors lose confidence in the market, they’ll offer lower bids on safe investments, such as Treasuries.
The Federal Reserve can also influence interest rates by adjusting benchmark interest rates, like the federal funds rate. If the Fed boosts market rates, it can cause an increase in bond rates, too.
Inflation can also play a role. During periods of higher inflation, investors will demand higher interest rates to ensure they receive similar returns in real terms.
What’s been going on lately with Treasuries?
In recent months, the yield curve has inverted. For example, on July 5th, the yield curve flipped with the yield of two-year Treasuries rising to 2.95% while 10-year Treasuries stood at 2.94%. The two-year to five-year yield curve also inverted.
Today, the curve remains inverted, with one-year Treasuries paying 4.285%, two-year Treasuries paying 4.302%, 10-year Treasuries paying 3.929%, and 30-year Treasuries even less at 3.917%.
This has happened amidst rising interest rates and falling bond prices in general. Over the past year, the interest rate of the 10-year Treasury has increased from a December low of 1.341% to a high of 3.955%. Rates have increased due to the Federal Reserve’s efforts to fight inflation by boosting its benchmark interest rate.
What Investors Can Do
While an inverted yield curve is generally a bad sign for the market, there are some steps investors can take in response.
Inverted yield curves can predict coming recessions, but they aren’t a 100% perfect indicator. Though the market may drop in the coming months, there’s also a chance that the yield curve returns to normal and the market recovers.
If you have a strong investment strategy, stay the course and try not to give in to the temptation to take drastic actions that could impact your overall returns.
Buy the dip
If a recession and market drop do follow the inverted yield curve, it gives investors the opportunity to buy stocks at a discount. If you have a solid source of income through the recession, continue investing and try to buy the dip.
If you can buy good stocks at a lower price, you’ll be well-positioned to earn a profit as the recession ends and the market recovers.
Consider how the yield curve impacts businesses
Some companies may be more impacted by changes in the yield curve than others. For example, businesses like banks and lenders that thrive on borrowing and lending money may see disruptions to their normal operations and profitability when the yield curve inverts.
This can give you a chance to buy shares at a discount. Alternatively, you may decide to avoid these investments that could be hurt by the inverted yield curve.
The Bottom Line
Recent months have seen the yield curve inverted, which can be a negative sign for the economy. Though inverted yield curves can herald recession, there are still steps investors can take to put themselves in a position to earn a profit. Be prepared to deal with falling stock prices and you might be able to buy high-quality shares at a discount.
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