When holding an investment long-term earns a lower return than holding the investment short-term, it’s not a good sign.
An inverted yield curve, which is what happens when 10-year Treasuries yield less than two-year Treasuries, is usually a sign that a recession is coming. Every recession of the past 60 years has been preceded by an inverted yield curve, according to research from the San Francisco Federal Reserve Bank.
The yield curve hasn’t inverted yet, but it’s coming pretty close and is likely to invert soon. Recently, the gap between short- and long-term yields was close to an 11-year low. The two-year Treasury recently closed with a yield of 2.69%, up from 1.92% when 2018 began, while the 10-year Treasury was below 3%.
When the economy is strong, the yield for long-term bonds is usually higher than the yield for short-term bonds. The extra interest is needed to compensate investors for the risk that economic growth will cause inflation to increase.
Today, unemployment is the lowest it’s been in 18 years and the economy is growing at its fastest rate since before the Great Recession. Yet “long-term bond yields have been stubbornly slow to rise — which suggests traders are concerned about long-term growth — even as the economy shows plenty of vitality,” according to The New York Times.
Fed Causing Inverted Yield Curve?
So why is the yield curve inverting?
As The Wall Street Journal recently reported, “Several analysts say the recent flattening of the yield curve has mostly been driven by monetary policy and continued growth — and not by fears of an imminent slowdown in expansion.”
The Federal Reserve Board controls short-term interest rates, but long-term rates are set by the market and reflect future growth expectations. The Fed has been raising rates after eight years of zero interest rate policy (ZIRP). While rates are still below historical averages, the Fed has raised rates six times since December 2015.
Meanwhile, the Fed has begun reducing its $4.5 trillion portfolio, much of which had shifted to long-term bonds. A larger supply of long-term bonds would result in lower yields.
Stock Market, Economy May Still Perform Well
Even if an inversion can’t be avoided, it doesn’t necessarily mean a recession is imminent.
Consider that the stock market has produced gains in four of the last five periods when the yield curve inverted. Going back to 1978, the S&P 500 has risen about 16% in the 18 months following an inversion, according to a new analysis by Credit Suisse. Over 24 months following an inversion, stocks rose an average of 14% and over 30 months, they rose an average of 9.5%.
Credit Suisse also found that when the yield curve inverts, a recession typically doesn’t follow until two years later.
While other factors point to a potential slowdown in the fourth quarter, it appears that a recession remains far away, even if the yield curve inverts.