Turbulent markets have a knack for introducing esoteric financial terms into the broader lingo. The global financial crisis gave us “mortgage-backed securities” and “quantitative easing.” Repeated bouts of instability have popularized “volatility.”
This year, a perennial phrase has taken its turn in the spotlight: “yield curve.” And more than that, “yield curve inversion.”
The terminology may be inelegant, but the behind-the-scenes principles are worth understanding, as the yield curve can shed light on the direction of the economy and financial markets.
At its most basic, the yield curve reflects investor expectations. It’s historically been seen as a proxy for where fixed income investors expect the U.S. economy to go. Technically, it’s a graph that plots the relationship between yields and maturities for comparable bonds — most often, Treasury bonds.
In normal markets, a yield curve rises sharply before flattening out. That’s because investors demand higher yields — a measure of profitability — for making longer commitments. In this case, the yield curve is said to be upwardly sloping.
An inverted yield curve is basically the opposite, dipping before flattening out at the bottom. In this situation, investors might be selling shorter maturities (driving down the price, thus raising the yield), buying longer maturities (driving up the price, thus lowering the yield) or a combination of the two.
“An inversion is when yields for bonds with longer maturities fall below yields for comparable shorter term bonds,” explains Capital Group fixed income portfolio manager Ritchie Tuazon.
Historically, inverted curves have been harbingers of economic trouble. There are several reasons for this, but one is that Federal Reserve interest rate hikes tend to push up short-term Treasury yields, which can cause them to eclipse longer yields.
Such an inversion occurred earlier this year when yields for two-year Treasury notes edged above those for 10-year securities. It came amid a period of heightened turmoil: The Fed was raising rates to combat inflation; Russia’s invasion of Ukraine disrupted commodities markets; investors were smarting from China’s clampdown on certain industries; and COVID-19 continued to unravel supply chains.
The relationship between two-year and 10-year Treasury yields has since returned to a more typical alignment. But the shape of the curve still indicates uncertainty, Tuazon notes. It’s flatter than normal — the front end isn’t as steep, and the back end isn’t as flat. That’s because investors have yet to reach a consensus on how high the Fed will raise rates. The central bank has already increased rates to 1.75%, and is expected to go as high as 3.5% this year. However, some think policymakers will need to go much further, potentially causing significant damage to the economy.
“The market is in discovery mode right now,” Tuazon says. “People are trying to figure out if the Fed’s behind the curve or ahead of the curve.”
The yield curve is an imprecise indicator, Tuazon says. Though inversions have heralded recessions, they’ve sometimes appeared years ahead of actual downturns.
“It is a sign of distress, but it doesn’t say with any kind of certainty that a recession is coming,” he observes.
Additionally, there are questions about whether yield curve inversions wield the same predictive power as in the past. One school of thought holds that the prolonged era of rock-bottom interest rates — which stemmed partly from global central banks’ unprecedented intervention in financial markets — has distorted the yield curve’s crystal ball effect.
That’s why economists and market watchers also track metrics such as GDP, unemployment, retail spending, consumer confidence and a constellation of manufacturing and production data. Some of these have shown weakness — consumer sentiment, for example, has tumbled — but the jobless rate and household balance sheets have been strong, Tuazon says.
“We’re seeing a mixed bag right now, and we don’t know with any sort of certainty when a recession could come,” he adds.