Yield curve inversions: Here's what financial advisors need to know
The interest-rate flip has preceded nearly every recession since 1955. Understanding them, and their consequences, can lead to better portfolio decisions.
Recently, the US government yield curve has found itself “inverted” — that means interest rates on debt today are higher than interest rates on debt in the distant future, which is notable and unusual.
It’s also potentially indicative of a recession — yield curve inversions have preceded nearly every recession since 1955.
This primer seeks to provide investors with what they need to know to understand the current yield curve inversion and what it might mean for their portfolios.
What is a yield curve anyway?
When consumers borrow money from banks or other financial institutions, they can do so over various periods of time. For example, the typical auto loan has a maturity of 5 years, while the traditional mortgage has a maturity of around 30 years.
Based on your creditworthiness (the lender’s perception of how likely you are to pay back the debt), the maturity, and other factors, you will pay a specified interest rate on your debt.
Governments, corporations, and other entities also issue debt. For example, the US government issues debt of many different maturities, including:
Treasury Bills - short-term government debt with maturities less than a year
Treasury Notes - 2-, 3-, 5-, 7-, and 10-year government debt
Treasury Bonds - 20- and 30-year government debt
When investors plot the yields (interest rates) of debt of similar credit quality over varying maturities, they construct a yield curve. As you can see in the chart below, typically interest rates are lowest for shorter-maturity debt, rising for lengthier maturities before starting to flatten out around the 15-year maturity mark:
Hypothetical yield curve
What does the shape of a yield curve mean?
The structure of the yield curve is referred to as its “shape.” Under normal conditions, the shape of the yield curve is upwardly sloping (like the hypothetical illustration above), reflecting the intuitive reality that borrowers should have to pay a greater interest rate for money they will pay back further in the future.
However, the yield curve is not always “normal.” As market participants consider market conditions, appetite for risk, and more, the yield curve can change its shape through time, becoming flat (when interest rates on debt today are the same as interest rates on debt in the distant future) or inverted (when interest rates on debt today are actually higher than interest rates on debt in the distant future).
Recently, we have found ourselves in one of these non-normal environments, with the yield difference between 10-year treasury notes and 2-year treasury notes becoming negative. In other words, the interest rate is lower for a 10-year T-bill than it is for a 2-year T-bill.
US Treasury Debt yield curve
As of July 6, 2022
*Source: S&P Global *
This inversion has led many investors to prognosticate about the impending doom of a looming recession, since yield curve inversions have preceded nearly every recession since 1955.
10-Year Treasury Note Yield minus 2-Year Treasury Note Yield
Source: Federal Reserve Bank of St. Louis. June 1, 1976 to July 6, 2022, Gray areas indicate NBER-defined recessions
What makes yield curves change through time?
You may have noticed that the 30-year mortgage rate you may have paid a decade ago is quite different from the 30-year mortgage rate that you could borrow at today. Through time, many factors influence the interest rates at which market participants can raise new debt. These include factors such as:
Aggregate appetite for risk
When the economy is growing and inflation is surging, these rates tend to rise, and when growth is slower and inflation is low, these rates tend to fall. The yield curve’s shape changes daily as new expectations for the future are incorporated into rates and prices.
What factors drive yield curve inversion?
An inverted yield curve means that investors demand a higher yield to invest in short-term bonds than long-term bonds. This can manifest for a variety of reasons, not limited to:
- Rising federal funds rates
- the short end of the curve is more highly correlated with moves in the Federal Funds Rate than the long end
- Surge in demand for long-term bonds
- if investors are concerned about long-term investment prospects, they may seek to ‘lock in’ a rate of return by buying long-term bonds, providing downward pressure on yields (conversely, upward pressure on bond prices)
- Inflation expectations
- if expectations for short-term inflation are considerably higher than expectations for long-term inflation, investors may demand higher rates of return over the short-term to compensate for inflation risk
What does this mean for my portfolio?
The answer to this question depends on which portion of your portfolio you are concerned with.
On the equities side, there is little evidence suggesting that investors would be well served using yield curve inversions to time equity markets. When attempting to outguess the market, market timers need to be correct not once (on the way out), but twice (when to get back in). There does not seem to be an empirically reliable set of rules to make this evaluation.
For example, here are the results for a hypothetical investor who moved their equity portfolio to cash each time the yield curve inverted over the previous five decades, and then reinvested when the yield curve normalized.
Growth of $1
June 1, 1976 to July 6, 2022
*Source: S&P Global with Market Timing Strategy calculations from Vise *
As you can see, this timing rule would have led to significant underperformance relative to the S&P 500 Index. This is because yield curve inversions provide little predictive insights into the performance of equity markets. While yield curves have preceded previous recessions, they do not necessarily mark the start date of one. Further, the performance of the stock market and the economy are often different, as the stock market is forward looking and the economy is a point-in-time measure of conditions.
On the fixed income side, things get a little bit more complicated. Unlike equities, fixed income securities have a defined maturity and an observable yield. Further, when yields rise, bond prices fall, and when yields fall, bond prices rise. This presents investors with an opportunity to tailor their fixed income exposure based on the current yield curve environment. For investors that believe the yield curve will eventually return to its normal, upwardly sloping shape, there are singular or a combination of things that must happen:
Short-term yields fall down below long-term yields: short-term bonds experience upward price pressure and positive returns
Long-term yields rise above short-term yields: long-term bonds experience downward price pressure and negative returns
A combination of both effects
Through this theoretical framework, it is logical that positioning your fixed income portfolio to be shorter in average maturity could help investors outperform in an environment like the one we find ourselves in.
In fact, there is significant empirical evidence that shows when yield curves are normal and steeply upward sloping, investors are rewarded for taking additional maturity risk, while when they are flat or inverted, investors are better off shortening the average maturity of their portfolio.
How Vise can help
Advisors using Vise can quickly alter proposals for client accounts to limit exposure to longer dated bonds, removing asset classes like intermediate-term treasuries and intermediate-term corporate bonds. This will shorten the average maturity of the portfolio, reducing duration risk and concentrating more holdings on the higher yielding portions of the yield curve.
There is no telling whether this latest yield curve inversion is a harbinger of an impending recession, or if it will transform into a previously useful indicator that no longer exists.
Fortunately for investors, the predictive power of inverted yield curves to forecast recessions is not the important question at hand. That question is whether or not we can use information in yield curves to make better portfolio decisions. On the equity side, the answer seems to be no, but on the fixed income side, there may be an opportunity to tailor exposure to take advantage of the transparency of yield curves.
The author, Christian Boinske, is a senior investment strategist at Vise.
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July 27, 2022