Un-Inverting the Yield Curve: What it Means for Investors

The yield curve, a popular recession predictor on Wall Street, has been showing signs of un-inverting recently. However, this news may not be all positive for investors. The way the curve un-inverts is just as important as the fact that it does.

Since July 2022, the yield curve has been downward sloping, with shorter-term interest rates on U.S. Treasuries surpassing those on longer-term securities. This inversion of the yield curve goes against the typical pattern, where longer-term investments usually have higher yields due to the expected inflation and interest-rate uncertainty over time.

Yet, over the past 15 months, investors have been factoring in higher interest rates and economic risks in the short term. As a result, yields on shorter-term treasuries have exceeded those on longer-term ones. This phenomenon has historically served as a reliable indicator of an impending recession. In fact, an inverted yield curve has preceded every U.S. recession since the 1950s. The time between the inversion and the start of a recession has ranged from as short as seven months to as long as two years, according to Dow Jones Market Data.

In early July, the 2-year yield exceeded the 10-year yield by almost 1.1 percentage points. This marked the largest spread between the two yields since March, following the failure of Silicon Valley Bank. It was also close to levels last seen in the 1970s and 1980s.

Today, that spread has narrowed to 0.29 points, with the 2-year yield at 5.07% and the 10-year yield at 4.78%. Additionally, other parts of the curve have already un-inverted. The yield on the 30-year Treasury bond currently stands at 4.94%, surpassing the yields of the 3-, 5-, and 10-year bonds. Moreover, the six-month Treasury bill now offers the highest yield on the curve, reaching 5.58%.

The manner in which the yield curve un-inverts is crucial. There are two possible scenarios—either the 2-year yield falls more rapidly than the 10-year yield, or the 10-year yield rises more swiftly than the 2-year yield. Both scenarios lead to a steeper yield curve. The former is known as a bull steepener and generally occurs when markets anticipate imminent interest-rate cuts by the Federal Reserve, resulting in a sharp decline in short-term yields. This is often a sign that a recession may be approaching.

The Impact of Bear Steepening on the Economy

By Nicholas Jasinski

In recent times, the phenomenon of bear steepening has gained significance due to the prevailing economic and labor-market strength. This trend has led to an upward shift in long-term yields as investors factor in the Federal Reserve's expectations of higher interest rates in the long run. Additionally, factors such as ongoing quantitative tightening by the Fed and an influx of Treasury issuance have contributed to this development. Consequently, this bear steepening has various implications for financial conditions, interest rates for borrowers, and competition among different asset classes. Moreover, these effects can heighten the probability of a weaker labor market and a potential recession.

From an economic standpoint, the impact of this bear steepening is notable. Tan Kai Xian, a U.S. analyst at Gavekal Research, predicts that U.S. non-financial firms will experience a surge in net interest expenses as a result of these factors. In the current cyclical phase, higher net interest expenses can impede corporate profits, prompting profit-focused companies to lay off employees.

This phenomenon is primarily observed as individuals and businesses tend to borrow over longer terms while holding their cash in short-term instruments. With a bear steepening scenario, the interest expenses incurred from borrowings surpass the returns gained from cash equivalents, resulting in higher net interest expenses for borrowers. Consequently, this becomes a drag on the overall economy.

It is essential to acknowledge that bear steepenings occur less frequently than their counterpart, bull steepenings. Jonas Goltermann, deputy chief markets economist at Capital Economics, clarifies that bear steepenings typically arise during the early stages of an economic cycle when growth is picking up. However, when the yield curve bear steepens while already inverted, as it presently is, it often indicates the start or proximity of a recession. Historically, this has been followed by significant declines in long-term government bond yields and equity indices.

While the current bear steepening suggests a potential recession, there is still the possibility of it transforming into a bull steepener. If a recession scare were to increase Wall Street's demand for long-term Treasuries and prompt the Fed to cut short-term rates, this transformation could occur. Nevertheless, such a shift would not materialize without economic and stock market challenges.

In conclusion, the bear steepening trend in the economy carries significant implications for borrowers, corporate profits, and the overall economic landscape. It is important to monitor its development closely and recognize the potential consequences it may have in the future.