The Yield Curve: A primer and the current inversion

The yield curve, also known as the term structure of interest rates, is an important reading on economic health. Think of it as something akin to your resting heart rate or blood pressure readings. Just as your resting heart rate or blood pressure can be an important indicator for your future medical health, the yield curve can be an important indicator for future economic health. The only question is when the implications of the underlying condition will manifest in tangible outcomes. But before looking into current yield curve conditions, let’s examine what the yield curve is and how it is constructed.

The yield curve is a depiction of the relationship between the current yields of bonds across the entire maturity spectrum as of a specific point in time. So, to construct a yield curve, we plot the current yield of bonds of different maturities and connect those plots with a line to create a “curve.” Specifically, we plot the one-month maturity, the two-month maturity, the three-month maturity, the four-month maturity, the six-month maturity, the one-year maturity, the two-year maturity, the three-year maturity, the five-year maturity, the seven-year maturity, the ten-year maturity, the twenty-year maturity, and finally the thirty-year maturity.

Under “normal” or healthy economic circumstances, the yield curve is upward sloping. This means that with a “normal” yield curve, the short-term maturities uniformly yield less than the longer-dated maturities. This makes logical sense. If you are considering two different bonds with different maturities, you are going to require a higher rate of return from a five-year bond than you require from a three-month bill. Why? Because with the longer maturity bond, you are committing capital over a longer period and will need to be properly compensated for that commitment. Think of the extra yield for long-term bond commitments as an incentive paid to you for committing your capital for a longer period. Below is a picture of a normal yield curve taken from December 31, 2003. One can plainly see an investor is compensated with extra return for longer-term commitments.

Now, let’s turn our attention to the current yield curve as compared to the “normal” yield curve from 2003. The current yield curve as of May 17, 2024, in red looks like this:

When we compare the current yield curve to the “normal” yield curve of 2003, the nature of the current inversion is obvious. Near term rates (one-month to six-month maturities) are high and about the same, and then longer dated maturities pay us less than the short-term maturities. There is NO INCENTIVE to place capital into longer dated maturities. The effect of an inverted yield curve is that there is such a strong incentive to keep money in shorter term instruments that, in aggregate, this incentive drains money from long-term capital commitments and capital projects—which then retards or constrains economic activity. This is what the Fed wants with the current inflation problem aggravating the economic landscape. Economic activity should slow since there is no incentive to take on longer-term projects in the form of longer-term loans. The economy should slow, which in turn should relieve inflationary pressure. The risk of the Fed’s inflation fighting tactic of keeping rates “higher for longer” is that it could bring about an economic recession.

Historically, an inverted yield curve has been a reliable predictor of economic recessions. In the modern era, every single yield curve inversion has preceded an economic recession. And this makes complete sense in the context of rates and incentives for investors, as discussed. Below is a picture of the yield curve over time using a slightly different convention than the curves previously shown. Rather than depicting the entire yield curve, we are showing the relationship between the ten-year note and the two-year note. In each period of time, we subtract the yield of the two-year note from the yield of the 10-year note, creating a plot of that specific difference on a specific date. We then make this same calculation through time and create a line over time depicting the difference between the two yields. It looks like this:

As can be seen, when the yield curve inverts, it tends to lead to recession (depicted by the grey bars in the chart). The current inversion has been of an extended duration and depth not seen since the early 1980’s. Will it be different this time? Maybe, but probably not. So far, the economy has remained reasonably strong, but there are some signs of slowing. Whether this slowing will lead to outright recession is still an open question. The Fed is clearly tapping the economic breaks to slow inflation. To rid the economy of the inflationary scourge may require they bring on recession. This is akin to eating healthy and engaging in exercise to bring down blood pressure and improve a resting heart rate. Ultimately these things lead to better heart health. Similarly, low inflation leads to a healthier economy.

We at WealthPlan do not know exactly what the future holds. Within our bond portfolios, we are currently emphasizing shorter duration bond investments. Given the yield curve environment, this makes sense to us. Our investors are enjoying reasonably strong current income while we wait for the economic picture to unfold. In the meantime, we continue to emphasize high quality growth and dividend growth in the stocks we choose to buy for our clients. This combination is a prudent strategy for building long term wealth.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which Investment(s) may be appropriate for you, consult your financial advisor prior to investing. Information is based on sources believed to be reliable, however, their accuracy or completeness cannot be guaranteed.

No investment strategy can assure success or completely protect against loss, given the volatility of all securities markets. Statements of forecast and trends are for informational purposes and are not guaranteed to occur in the future. All performance referenced is historical and is no guarantee of future results. Securities investing involves risk, including loss of principal. An investor cannot invest directly in an index.