What Does the Yield Curve Inversion Mean?

After more than a decade, the yield curve has finally become flat. By yield curve, I mean the difference between short-term and long-term interest rates.

Normally, the yield curve is upward sloping, meaning you get paid more the longer you lend your money. That makes sense. But every so often, the yield curve goes flat, or even gets inverted. That’s when short-term rates rise above long-term rates.

An inverted yield curve is one of the few good predictors of a bad economy. For a field with lots of stats, we still have little idea of how well the economy is doing at the moment. Economists have a terrible track record of predicting recessions, but the yield curve could have won a few Nobel Prizes based on its track record. The spread between the 2- and 10-year Treasuries has been an omen of bad times consistently for the last 35 years. Notice how often a negative spread precedes a gray recession bar.

That spread is still slightly positive but on Friday’s close, the yield on the three-month Treasury was 2.46%. That’s two basis points more than the 10-year yield. For context, in 2010, the two-year was more than 380 basis points less than the 10-year yield.

The yield curve is important but I’ll caution investors that it’s not an instant tripwire. For example, the 2-10 spread inverted in May 1998. It then went back before becoming very inverted in 2000. The recession didn’t officially begin until 2001. Even in the last recession, the 2-10 spread inverted in late 2005. The recession didn’t start for two more years.

Still, it’s important. It’s a mistake to dismiss the yield curve as a technical indicator like the 200-day moving average. The yield has real world ramifications. A few years ago, I ran the numbers and found that the stock market does much better when the spread between the 90-day and 10-year Treasury yield is 121 basis points or more.

If you’re a bank, an inverted curve means it’s not profitable to borrow short and lend long. (However, starting a bank in 2010 was probably one of the most profitable things you could do.)

Think of it this way: the yield curve is a yellow light, not a red one. We’re still going to proceed, but with caution.

Posted by on March 25th, 2019 at 12:22 pm


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