The 3-Month Treasury Bill rate is currently 5.48%, the highest among all US treasury maturities, it was near 0% at the beginning of last year.
The 3-month rate is currently higher than the 3-year by 72 basis points. At the end of May, the 1-Month Treasury Bill eclipsed 6% for the first time ever and was the first treasury instrument to do so since 2002.
This is a situation known as an inverted yield curve. An inverted yield curve is when shorter-term notes pay higher effective yields than longer-term bonds. The yield curve is considered “normal” when longer-term bonds yield more than shorter-term ones.
An inverted yield curve historically signals that the broader economy might be headed for some tough times. Yield curve inversions are regarded by many as warning signs of a recession, as they have consistently preceded US recessions. They also indicate uncertainty in equity markets.
How much should you worry about this yield curve inversion? Is a recession coming? And if so, how soon? Who tends to be the winners and losers of an inverted yield curve?
What Inverted Yield Curves Mean for Recessions
Generally, investors receive higher returns when they agree to commit their cash for longer time periods. The fact that an investor today can lock in a 5.48% effective annual yield with principal paid back in 3-months, but just 4.33% for one decade doesn’t sound quite right, does it?
An inverted yield curve occurs when near-term risks increase. Investors demand greater compensation from shorter-term treasuries when long-term expectations for the economy sour.
Inverted yield curves can be more clearly illustrated through yield spreads. Two of the most closely followed spreads are the 10 year / 2-Year Treasury Yield Spread and the 10 Year / 3-Month Treasury Yield Spread. The 10 / 2-year spread inverted at the beginning of July last year and has stayed negative since, stirring up fears of a recession.
At the same time, the technical definition of a recession was met early last year when two consecutive quarters of negative GDP growth were logged between Q1 and Q2 2022.
The 10 / 3-month spread is also a popular recession indicator and represents the relationship between long-term bonds and what’s often considered the risk-free interest rate. In late October, the 10-year/ 3-month spread turned negative for the first time since February 2020.
There have been six major US recessions since 1976, per the National Bureau of Economic Research’s definition and ALL six recessions were preceded by an inverted 10 / 2-year spread lasting longer than two months. Each recession (other than the 2020 pandemic-induced one) occurred less than two years after the 10 / 2-year spread first inverted.
An inverted yield curve doesn’t necessarily mean a recession will happen at the snap of a finger. Nor have yield spreads historically stayed negative for very long. In fact, recessions don’t typically occur while the yield curve is inverted. Instead, what often happens is that the yield curve starts to gradually “un-invert” shortly before a recession. This reversal is usually triggered by either rate cuts or the imminent possibility of them, leading to a decrease in short-term bond yields.
Analysts believe the yield curve could remain inverted longer than usual due to the large yield gap and strong economy. The conclusion of the inversion will reveal whether it is caused by declining interest rates or new bets on the economy’s strength.
Despite recent economic resilience, recessions have historically occurred within two years of a negative 10 / 2 spread. This, combined with achieving a technical recession by way of two consecutive quarters of negative GDP growth last year, explains the jump in near-term recession probability.
How Consumers Can Be Affected by Inverted Yield Curves
Consumers seeking short-term loans tend to be worse off amidst an inverted yield curve. Interest rates rise and costs of borrowing go up, leading consumers to either pay higher prices or defer purchases and investments altogether.
This unfriendly environment tends to sour the consumer’s mood. Though yield curve inversions tend to precede recessions, decisions made by consumers can ultimately flip the switch and force the economy into contraction.
For each of the six recessionary periods listed above, and also at the time of an inverted 10/ 2 year or 10 / 3-month spread, the University of Michigan’s US Consumer Sentiment Index was either declining, below its historical average, or both. The same goes for the US Consumer Price Index, which was either on the rise, above its historical average, or both in all six periods.
The Consumer Sentiment Index hit an all-time low of 50 last June right as the 10 / 2-year spread turned negative, and inflation peaked at 9%. The index is currently around the same level as it was at the end of the Great Recession of 2007-2009.
The 10 / 3-month spread moved in the opposite direction of consumer sentiment last year. As the Consumer Sentiment Index plummeted to historical lows, the 10 / 3-month spread widened. It seems the 10 / 3-month spread caught up to the reality of depressed consumer sentiment and the highest CPI in four decades.
How Equities Can Be Affected by Inverted Yield Curves
Companies in the business of short-term borrowing and long-term lending, such as banks, have historically underperformed when the yield curve inverts. Borrowing costs increase near-term, and profits get compressed when long-term loans are issued with less attractive rates.
Stocks bearing high dividend yields are also thought to be less attractive when short-term rates spike. Yield-seeking investors may flee equities in favor of shorter-term treasuries since payments can be captured without inheriting company risk.
On the flip side, companies that issue short-term loans would expect to see a bump in interest payments. The same goes for companies with large amounts of liquid assets on their balance sheets.
How Fixed Income Can Be Affected by Inverted Yield Curves
Inverted yield curves raise short-term US treasury yields closer to those of riskier bond types such as junk bonds, corporate bonds, and also real estate investment trusts (REITs). When the spreads between lower-risk US treasuries and these higher risk, non-Treasury backed securities contract, the US treasuries are typically seen as more attractive.
When a flat or inverted yield curve lifts short-term treasury rates closer to or greater than long-term ones, this presents a situation in which investors could lock in a similar interest rate at a lower duration (lower interest rate sensitivity) to maturity. One thing to note: if short-term rates continue rising, then that bond value would likely decrease. However, assuming the investor is willing to accept implied short-term risk and believes the issuer, in this case, the US government won’t default, he or she might have an opportunity to achieve a greater effective yield.
The Bottom Line
The yield curve has been inverted since July 2022, but history has shown that any economic fallout following a yield curve inversion doesn’t happen immediately. Investors that take cues from the 10 / 2-year spread might look to the 10 / 3-month spread as well, as both have preceded all six recessions that have occurred dating back to 1980.
-Paul R. Rossi, CFA