What Is An Inverted Yield Curve And What Does It Mean?

There has been extensive discussion over the last few weeks over an “inverted” yield curve, so what is it exactly?

Bonds and yield curves are interrelated. In short, a bond is an agreement stating that if you give a government or entity money, they will pay the money back in the future plus pay a stated amount of coupon interest annually.

A yield curve represents the different interest rates paid to bond holders of U.S. government bonds based on maturity dates (one month to 30 years). Typically, as the borrower holds onto an investor’s money, the investor will demand a higher rate of interest the longer their money is held away. In practical terms, owners of a 30-year U.S. treasury are paid more than owners of a one-month treasury bond. The higher interest rate compensates a bond holder for the longer term and therefore higher risk the investment could fail.

A real-life example: Imagine a friend wanted to borrow money from you and he proposed either 2% annual interest paid back in two years or 1.75% annual interest paid back in ten years.  It would be clear there was something wrong with this offer and you would likely go with the higher-interest earning and lower-risk (shorter) term note.

The graphical representations of yield curves are below. As discussed above, the Normal Yield Curve illustrates a higher yield over time. The Inverted Yield Curve shows the opposite; as time goes on, the lower the yield.

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We find ourselves today in the strange times where the yield curve is inverted. Although this has preceded the last seven recessions, with an average lag time of 15 months, it was not the cause of those recessions. Rather, it is a partial representation of how the market views future economic growth. An inverted yield curve means investors are flocking to buy secure, long-term steady returns through longer-dated U.S. Treasury bonds over other assets.  This strong demand pushes bond prices up, which lowers the interest rate, because bond prices and yields move in opposite directions. Investors are expressing a bleaker-than-normal, short-term outlook and would rather remove risks their portfolios and lock in secure long-term government bond returns.

Recessions tend to be bad for stocks so you would think an inverted yield curve could help predict future stocks returns. Two professors published a paper in 2019 researching 11 major stock and bond markets from 1975-2018 ^a. They looked at six different yield spreads and switched from stocks to cash when the curves inverted. Comparing returns over one through five-year periods, they found no evidence that an inverted curve can predict stocks will perform worse than cash.

We continue to monitor the status of the bond market and other economic indicators. Our internal and external investment managers have been providing continuous insight, and we are grateful have them on the Foundation team. Should you have any questions, concerns, or like to discuss in greater depth, please do not hesitate to reach out.

Sources

^a https://famafrench.dimensional.com/media/467645/inverted-yield-curves-and-expected-stock-returns-july-28-2019.pdf