Yield curve inversion: Understanding the fire alarmContributor Alex Dryden
- The yield curve, specifically its potential inversion, has become a trusted signal of impending economic turmoil due to the close historical relationship between inversions and recessions.
- The flat yield curve is giving off mixed signals, but the near-term spread is currently telling investors to proceed with caution.
- The current flatness of the yield curve is making duration management challenging for investors. Investors should likely look to the back end of the curve for protection and look to the front end of the curve for a stable income stream.
What is the yield curve currently telling us?
The current flatness of the yield curve, as shown in Exhibit 1, is providing mixed signals for investors. There are a few points on the curve that are inverted, normally a sign of stress, such as the difference between the three-month T-bill and the 10-year (3m10s), and then other areas where inversion has not yet occurred, such as the spread between the two-year and the 10-year (2s10s).
The current shape of the curve is puzzling. In the build-up to the past three recessions, the 2s10s spread inverted first, followed by the 3m10s roughly six months later. This time, however, the 3m10s has inverted while the 2s10s has not. This likely reflects the bond markets anticipating a prolonged rate cutting cycle over the next two years. However, since the cutting cycle has yet to begin, the 3-month yield remains above the 2-year yield.
But despite the puzzling nature of the present yield curve, investors should be cautious about reading too deeply into its shape. In our August 2018 paper, Yield curve inversion: Should we trust the alarm , we outlined the theory behind yield curve inversion and how it may send off mixed signals, especially after a significant asset purchase program (quantitative easing). Indeed, the odd behavior of today’s yield curve adds further credence to the idea that investors may be better off looking to alternative indicators and metrics that can help provide clearer guidance on the direction of the economy.
Exhibit 1: Yield curve
U.S. Treasury yield curve