Inverted Yield Curve Basics

Everyone’s talking about the inverted yield curve and how it could signal a recession. Robert Tipp, chief investment strategist and head of global bonds for PGIM Fixed Income, addresses some of today’s frequently asked questions.

September 03, 2019

What is an inverted yield curve?

An inverted yield curve is when yields on long-term Treasury securities are lower than yields on short-term securities. Most of the time, yields on cash, money market funds, bank deposits and short-term Treasurys are lower than long-term Treasurys such as 10-year, 20-year and 30-year bonds. But there are times in the business cycle when short-term interest rates are higher than long-term Treasurys, and that’s called an inverted yield curve.

For illustrative purposes only.

Why is everyone talking about it?

Historically, inverted yield curves have often preceded economic slowdowns. So investors have been conditioned to worry about the onset of an inverted yield curve as potentially signaling the possibility of a recession and downdraft in the markets.

Source: US Department of the Treasury. There is no guarantee that he projection shown would be achieved.

 

The visual shows 2 lines. The first gray line charts the differential between the 10-year and 2-year U.S. treasury yields from 1990 through August 2019. The second blue line charts the cumulative growth of the S&P 500 Index from 1990 through August 2019. The call out box in the chart states, “Historically, when the yield curve is inverted, there exists a high correlation with a market downturn. There are dark red shading on the 10-year/2year yield differential line chart to signify when the yield curve is inverted and dark blue shading on the S&P 500 line graph.

 

Why is this happening?

Two opposing factors caused the inverted yield curve. First, over the past few years, the Fed pushed short-term rates up about 2%. Second, long-term rates have fallen, pushing them a bit below the short-term rate, inverting the yield curve. While in past cycles the drop in long-term rates signaled investors’ concerns about a slowing economy, this time the drop in long-term rates has likely been exaggerated by the low level of foreign interest rates. Negative long-term rates in Europe and Japan have likely resulted in above-average demand for U.S. long-term bonds. This demand has likely pushed down long-term U.S. rates and contributed meaningfully to the inversion of the yield curve.
 

Is a recession coming?

While we can’t be sure, in our view the odds of a recession currently look quite low. The economy is growing reasonably well. The Fed has reversed course after its modest hiking cycle and is trying to foster growth by cutting rates. Unlike past inversions, interest rates are quite low—probably low enough to boost growth after their recent decline.
 

How is PGIM responding to the inversion?

We continue to be guardedly optimistic that we’re not facing an imminent recession. So we are taking advantage of opportunities in the market to get incremental yield in sectors we think will benefit from this economic environment of ongoing moderate growth and stable inflation.
 

Should individuals be making any financial moves?

Investors always face uncertainty. The best course is usually to stick with your long-term strategy and not make ad hoc adjustments based on the latest news headlines. At PGIM Fixed Income, we believe that’s the case today as much as ever. But you should talk to a financial professional about your own situation before making any moves.


 

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