Economic Insights
What an Inverted Yield Curve Could Mean for Investors
With long-term Treasury yields once again dipping below short-term yields, we examine the implications for the U.S. economy, U.S. Federal Reserve policy, and key asset classes.
Like the rest of the investment world, we have been watching the U.S. Treasury yield curve very carefully, especially after the March 22, 2019, inversion of three-month/10-year Treasury rates. Inversion has once again become a focus in recent weeks: As of June 4, the broad yield curve, which measures rates across the Treasury maturity spectrum, had a downward slope from very short maturities to the three year point, sloping upwards thereafter.
Chart 1. State of Inversion: The U.S. Treasury Yield Curve
Yield on U.S. Treasuries for indicated maturities, as of June 4, 2019
Source: Bloomberg. Chart represents yield of U.S. Treasury securities across available maturities as of June 4, 2019.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.
In our view, the current curve reflects market expectations that the U.S. Federal Reserve’s (Fed) policy arm, the Federal Open Market Committee (FOMC), will reduce rates by 75-100 basis points from the current 2.375% mid-point of the Fed funds target range over the next 12 months.
Since the FOMC has shown a distinct preference for multiple small rate cuts as opposed to fewer, larger moves, it is not unreasonable to believe that if it does start easing, it will end up doing so multiple times before rates stabilize at a lower level. Of course, a “one and done” approach is not unheard of, but is usually applied to quell financial risk. Case in point: The Fed’s move to calm markets amid the Russian debt default in 1998.
Gauging Recession Risk
A closer look at recessionary periods after the 1960s reveals that the yield curve inverted before each downturn. However, if we exclude isolated months that are far removed from economic peaks, the lead time between the initial inversion and the subsequent business cycle peak varied widely.
For example, since financial deregulation in the late 1970s, the three-year/one-month version of the Treasury curve has inverted between five and 19 months before a U.S. recession started. Moreover, it flashed at least nine false signals during that period—inversions that were followed by de-inversions as investors’ expectations about Fed policy proved ill-founded.
Chart 2. An Inverted Yield Curve Signals Recession—Except When It Doesn’t
Yield curve differential of the three-year U.S. Treasury note and the one-month U.S. Treasury bill (monthly except for endpoint), June 30, 1961–June 4, 2019
Source: Bloomberg. Shaded areas indicate recessionary periods. False signals are points at which the yield curve inverted and then subsequently turned positive without occurrence of recession.
Performance quoted above is historical. Yield curve represents differential between three-year and one-month U.S. Treasury yields. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.
Thus, the market doesn’t have systematically superior knowledge to the Fed, although it does understand that the Fed tends to cut rates in a series of small moves that cumulatively add up to something larger.
Fed Signals
The current environment is one in which forecasting rate cuts is particularly difficult and very likely makes the Fed yield curve inversion signal even less reliable than it has been in the past. Two reasons why:
- The Fed only started targeting 2% inflation in 2012, and nobody knows the relative weighting it attaches to meeting its inflation objective versus meeting its goal of fostering maximum employment; under current circumstances, the “dual mandate” is more opaque than usual.
- Low inflation and low inflation volatility have narrowed the term premium—the risk premium for maturity extension and other factors—or even turned it negative. This makes it much easier for the yield curve to invert without necessarily signaling rate-cut expectations consistent with recession.
Both factors make it likely that the current yield curve inversion is an even noisier signal than it has been in the past, lengthening the lead time between inversion and a potential recession.
The best response to this is to call on other indicators that have been more reliable guides to cyclical peaks; leading economic indicators (as represented by the Composite Index of Leading Indicators) and broad financial conditions (as measured by the Chicago Fed National Financial Conditions Index). (See our in-depth analysis in the April 12, 2019, Fixed-Income Insights.) Both currently negate the recession warning given by the inverted yield curve and suggest the end of the current economic expansion is not on the horizon yet.
Implications for Investors
Given the volume of media coverage of the recent curve inversion, investors may have a number of questions. What should they be thinking about in a low-rate environment in which the risk of near-term recession still appears small? If the yield curve returns to a positive slope, it’s likely that this will go hand in hand with investors becoming at least somewhat more positive about future economic growth and pushing back their forecasts of the starting date of the next downturn. If so, stocks and credit should outperform Treasury bonds handily, in our view.
A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk. Credit risk is the risk that debt issuers will become unable to make timely interest payments, and at worst will fail to repay the principal amount. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a guarantee or a reliable indicator of future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
Basis point is a financial unit of measurement that is 1/100th of 1%.
A bond yield is the amount of return an investor will realize on a bond. Though several types of bond yields can be calculated, nominal yield is the most common. This is calculated by dividing the amount of interest paid by the face value. Yield to maturity is the rate of return anticipated on a bond if held until it matures.
Fed funds are overnight borrowings between banks and other entities to maintain their bank reserves at the U.S. Federal Reserve (Fed). Banks keep reserves at Fed banks to meet their reserve requirements and to clear financial transactions.
Term premium is a gauge of the level of risk inherent in holding a longer-term bond versus a series of shorter-term securities. It represents the estimated risk embedded in a longer-maturity bond that is determined by the difference between the actual yield and the “risk neutral” yield (represented by rolling a series of shorter-term securities extending to the same maturity at current rate expectations).
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. One such comparison involves the two-year and 10-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. The curve is also used to predict changes in economic output and growth.
The Chicago Fed National Financial Conditions Index is a gauge of U.S. financial conditions compiled by the U.S. Federal Reserve Bank of Chicago. The index tracks measures of financial stress and tightness of credit markets
The Composite Index of Leading Indicators is an index published monthly by The Conference Board. It is used to predict the direction of global economic movements in future months. The index is composed of 10 economic components whose changes tend to precede changes in the overall economy.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.
The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.