A yield curve is a graphical representation of how much it costs to borrow money for varying lengths of time. The return an investor makes on a bond purchase is known as yield.
A standard yield curve slopes upward, as longer-term U.S. Treasury debt securities typically have higher yields than shorter-term ones. An inverted yield curve is the unusual situation in which shorter-term securities with the same credit risk profile yield higher returns than longer-term securities. Inverted yield curves are believed to indicate that a recession is coming, preceding every recession since 1957.
What determines the yield curve slope?
The yield curve generally slopes upward because the interest rates on long-term Treasury bonds are higher than on short-term bonds. Commonly, 10-year Treasury bonds are compared to 2-year or 3-month bonds.
It is riskier to tie up money for longer periods of time because there is a lot of uncertainty associated with long-term investments. Inflation, Federal Reserve policies, and the global economy can all impact your potential gains or losses over months and years. When you borrow long term, your lender will demand a higher interest rate (yield) to compensate for some of their financial risk.
When long-term rates go down, it indicates an expectation that the economy will worsen, and the Federal Reserve will cut short-term rates in the near future to stimulate borrowing.
When the spread or difference between short-term and long-term interest rates narrows, the yield curve starts to flatten. A flatter yield curve could be an indication that the yield curve will transition from an upward to a downward slope.
What about supply and demand?
Supply and demand can also impact the yield curve. When the demand for bonds and other debt instruments is high, the lender can offer lower interest rates. This can flatten the yield curve and lead some economists to argue that supply and demand, not a declining economy, is inverting the yield curve.
Bond prices and interest rates move in opposite directions. When demand for long-term bonds rises, their prices increase, and interest rates decrease. When there is an increase in demand for long-term bonds, it signals risk aversion, which can cause investors to sell their stocks and buy long-term government-issued bonds, which are commonly felt to be the safest available investments.
Does an inverted yield curve mean a recession is coming?
Historically, when the yield curve inverts, it is followed by a recession. However, supply and demand and term premiums can also change the slope of the yield curve. When long-term premiums are low, the yield curve is flatter. The curve can invert when there are smaller increases in short-term interest rates than long-term rates.
What does an inverted yield curve mean for investors?
Banks borrow money short term at low interest rates and lend it long-term at higher rates. When banks need to pay more to borrow money and don’t make up this added cost when they lend money, they stop lending as much to businesses, homeowners, and other borrowers. Businesses can’t expand, and people can’t buy more expensive houses. The economy slows.
The relationship between the inverted yield curve and a recession is correlation, not causation. However, many people will argue that it becomes a self-fulfilling prophecy. When investors believe the economy is slowing, they may pull money out of short-term investments and move it to longer-term ones.
How should you navigate an inverted yield curve?
While an inverted yield curve is associated with an upcoming recession, it is essential for investors to maintain a balanced and diversified portfolio.
Consider the following options:
- Take advantage of the higher yields on short-term investments by investing in more short-term bonds.
- Avoid making any hasty investment decisions.
- Keep your portfolio diversified, especially during times of economic uncertainty.
- Evaluate your risk tolerance before buying and selling current holdings. Fixed-income investors can use the yield curve to create a portfolio that balances risk and reward. Balancing a portfolio enables investors to weather changes in the yield curve.
- Consult with a financial professional for help navigating uncertain economic situations.
There is no one-size-fits-all guide to investment. Working with a wealth manager who uses a fee-only financial planning structure can ensure you make the best financial decisions for yourself and your loved ones. Ready to secure your financial future? Call us today at 866-395-1786 to get started.
