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An Essential Question About Yield Curve Inversion

Kevin T. Cooper, CFA®

Vice President | Head of Investment Research


For the first time in more than a decade, the yield curve has (partially) inverted. What does this mean for investors and the market in general?

Source: Factset, Federal Reserve

Specifically, the yields on one, two, and three-year Treasuries exceed that of the five-year Treasuries, as shown in the above chart.1 This is an unexpected situation, as investors are typically compensated with higher rates in exchange for holding bonds with a longer maturity.

The willingness to accept a lower yield over a longer period of time usually reflects concerns about the economy and/or markets in the short-run. As a result, investors are prioritizing purchases of long-term bonds (driving those yields down) over short term bonds (driving those yields up).

This situation raises one big question for advisors and their clients: what happens after the yield curve inverts?

First, an inverted yield curve makes short-term debt more expensive. This can notably impact consumers and businesses that have lines of credit, adjustable-rate debt, or other short-term loans tied to short-term interest rates.

More importantly, the larger concern with inversion is the potential of a recession. Take a look at the yield curve from two important time periods, January 2000 and November 2006:

Source: Factset, Federal Reserve

Back in January 2000, the yield on 10-year Treasuries slipped below that of 5-year Treasuries by a single basis point (6.68% vs. 6.69%). The same thing happened in November 2006 (4.62% vs. 4.63%). In the latter case, yields on 2-year Treasuries were even higher than their 5 and 10-year counterparts, resulting in an even more-pronounced inversion.

What happened after these inverted yield curves appeared?

  • Approximately 15 months after the January 2000 inversion the U.S. entered a recession while the dot-com stock market bubble was bursting.
  • Approximately 14 months after the November 2006 inversion the U.S entered a recession as the ’08 financial crisis started to play out.

 

Taking a broader historical perspective, an inverted yield curve has appeared prior to the last seven recessions.2  Of course things are rarely that simple. An inverted yield curve is not a cause of a market downturn or recession and does not guarantee a pending recession. It’s worth noting that:

  • There can be varying periods of time before the markets or economy shift after the yield curve inverts. In the examples above the initial inversion occurred more than a year before the recessions hit.
  • There are generally opportunities for investors in every market situation. 

 

The point is that investors should be aware of and monitor what happens with the yield curve, and consider how that may impact their clients. The fact that there is a partial inversion today is an event that may signal significant changes ahead in the economy and the markets.

 

Sources: FactSet, Federal Reserve as of 12/07/18.

https://www.cnbc.com/2017/06/05/inverted-yield-curve-predicting-coming-recession-commentary.html


The yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is used to predict changes in economic output and growth.

All investments are subject to risk including possible loss of principal.

Charts and graphs included in this presentation are not meant as investment tools or to assist with investment decisions. Information has been obtained from sources believed to be reliable, but its accuracy, completeness, and interpretation are not guaranteed. The foregoing discussion is general in nature, is intended for informational purposes only and is not intended to provide specific advice or recommendations for any individual or organization. Because the facts and circumstances surrounding each situation differ, you should consult your attorney, tax advisor or other professional advisor for advice on your particular situation.

 

AMG Funds are distributed by AMG Distributors, Inc. a member of FINRA/SIPC.

Not FDIC Insured | May Lose Value | Not Bank Guaranteed

WRITTEN BY

Kevin T. Cooper, CFA®

Vice President | Head of Investment Research

PUBLISHED: December 12, 2018

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