Of the hundreds of market and economic indicators that investors watch closely, perhaps none is as important as the shape of the yield curve. Not only does it summarize the state of the economy, but the level of interest rates across the yield curve directly affects investors, businesses, and individuals. For this reason, markets had a mixed reaction to the recent yield curve “inversion,” the first time it’s occurred since 2019, prior to the pandemic. In this article we’ll walk through what these terms mean and why they matter.
Although the yield curve is a technical concept, the basic idea is easy to understand. A yield curve is just a graph showing interest rates across different time horizons or maturities. In plain English, it tells you what interest rate you would earn if you invested in a new note or bond for that duration, be it 3 months or 30 years.
We’re in the post-pandemic economy
The world has changed significantly since then. Over the past two years, oil prices have recovered alongside the economy, with a few bumps due to growth concerns and COVID-19 variants. As a result, higher energy prices have been a major contributor to rising inflation. The January Consumer Price Index report, for instance, showed that energy prices rose 27% over the previous year and gasoline prices skyrocketed 40%.
Chart: The Treasury yield curve has flattened and inverted since the start of the year
Sources: Clearnomics, Federal Reserve
Rates are important to everyone
These rates are important for those investing for portfolio income, taking out a mortgage, applying for a personal loan and more. However, the yield curve is arguably much more important as an economic indicator. This is because the shape of the yield curve tells us about the health of the economy and where we might be in the business cycle.
Traditionally, economists and market professionals look at the difference between 10-year and 2-year Treasury yields. Since we often plot these yields on a graph, when the difference is large, we say that the yield curve is “steep” (it slopes upward to the right). When the difference is small, we say that the yield curve is “flat.”
Interpreting the curve
The shape of the yield curve changes throughout the business cycle. Early on, all rates are low as the economy comes out of recession. Long-term rates then begin to rise as growth picks up, followed by short-term rates that the Fed influences as it tightens policy. Eventually, the curve flattens and then “inverts,” when it instead slopes downward. This occurred recently when the 2-year rate rose above the 10-year.
The most important takeaway is that yield curve inversions may predict eventual economic downturns, but they don’t tell us about their timing. Of the six recessions since the early 1980s, some form of yield curve inversion occurred anywhere from 9 to 23 months before, during which markets often performed well. Many factors suggest that this time could be different as well, including the strength of the U.S. economy.
Don’t try to time the market
Thus, yield curve inversions are a blunt tool that should not be interpreted as a market timing indicator. Instead, history suggests that being positioned properly throughout these events, with an appropriate combination of stocks and bonds, is much more important. Trying to predict the exact timing isn’t just difficult — investors run the risk of missing out on opportunities in the meantime.