Treasury yields invert as investors weigh risk of recession

Investors continue to face unusual dynamics in the bond market today that date back to early 2022. Chief among which is the emergence of an “inverted yield curve.” This is a somewhat rare occurrence, when interest paid on shorter term U.S. government-issued bonds exceeds the interest rates on longer term bonds. While it may sound like an arcane event, history suggests that an inversion of the yield curve is a warning signal for the U.S. economy, potentially the precursor of a recession. How should investors react and what does it mean for the economy in today’s environment?

What is an inverted yield curve?

The concept of the yield curve starts with bonds of different maturities and is often based on yields of U.S. Treasury securities. These are bonds of equal credit quality (all backed by the full faith and credit of the U.S. government) but with different maturities.

A simple way to view the yield curve is to look at current interest rates, or yields, paid by U.S. Treasury securities with maturities of three months, two years, five years, 10 years and 30 years. Investors typically expect to be rewarded with higher yields when they invest their money for longer periods of time. This is referred to as a normal yield curve, one where yields rise along the curve as bond maturities lengthen. The chart below depicts a normal, upward sloping yield curve among these five U.S. Treasury securities, depicting actual yields in the Treasury market at the end of 2021.¹ At that time, the yield on 3-month Treasury bills stood at 0.05%, and moved progressively higher as maturities extended along the yield curve.

Source: U.S. Department of the Treasury

However, there are unusual circumstances where the yield curve “inverts.” The use of this term does not necessarily indicate that the slope moves from higher to lower when reading the chart from left to right. But it can mean that yields on some shorter-term securities are higher than those for longer-term securities.

In 2022, the yield curve first inverted on April 1 when comparing two of the key indicator rates along the curve – the 2-year Treasury note and 10-year Treasury note.¹ After a short period of time, yields reverted to a normal curve, but an inversion between the 2-year and 10-year Treasuries occurred again in early July 2022. Just a few months later, in late October, the yield on the very short-term 3-month Treasury bill moved above that of the 10-year Treasury note. The inversion became more pronounced toward the end of 2022 and the spread widened in 2023. Interest rates paid by 3-month Treasury bills are now more than 1.75% higher than those available from 10-year Treasury bonds.

Source: U.S. Department of the Treasury

As of June 5, 2023, the yield on the 3-month Treasury bill was 5.46% while the 2-year Treasury note closed at 4.46%. By comparison, the yield on the much longer-term 10-year U.S. Treasury note was 3.69%.

Some analysts see this rare event as a key economic signal, with many speculating that it foretells a future recession. Rob Haworth, senior investment strategy director at U.S. Bank, believes the inversion of yields between 3-month and 10-year Treasury securities is particularly notable. “It represents a higher cost for corporations,” says Haworth. “With short-term rates so high, companies are increasingly reluctant to borrow, as it makes it more challenging to realize a payoff when investing the borrowed capital in new equipment and facilities or added employees.” Haworth indicates that this can be a precursor to a slowdown in economic activity.

Signs of a recession?

How reliable of a recession indicator is the inversion of 3-month and 10-year Treasury yields? “It’s hard to know for certain, but historically, when we see such a significant inversion, it typically points to a recession,” says Matt Schoeppner, senior economist at U.S. Bank. “Banks tend to start pulling back from lending in this type of environment, and higher interest rates also dampen consumer borrowing.”

Schoeppner adds that while these factors are potential harbingers of an economic downturn, it’s not yet a foregone conclusion. “While bank lending has tightened, it’s not clear that it’s happening at a pace that is indicative of a recession,” says Schoeppner.

Haworth says that unusual factors leading to the current environment may alter expectations. “It’s important to remember that there was a significant amount of fiscal stimulus in the form of government payments to individuals and businesses that helped boost the economy,” he says, referring to government support programs during the early stages of the COVID-19 pandemic, which began in 2020. “Government support programs, along with monetary stimulus by the Fed created unusual circumstances leading into the current yield curve inversion cycle.” Haworth says given that the economy continues to grow, albeit at a slower pace, a recession may not be inevitable in the near term despite the bond market’s unusual dynamics.

He believes key signals about future economic strength will come down to whether labor market trends reverse, leading to rising unemployment. Recent data shows the unemployment rate at 3.7%, however, still lingering near a half-century low.² To this point, the strength of the labor market has helped keep the economy on a growth trajectory.

The Federal Reserve’s interest rate influence

Beginning with the last recession, triggered by the onset of the global pandemic, the Fed reduced the short-term federal funds target rate to near zero percent, which helped keep rates on short-term government debt securities low. As the first chart above (from 2021) shows, yields on the shortest-term government securities were near 0%. At the same time, the Fed began making monthly purchases of Treasury bonds and mortgage-backed securities, a step that helped moderate interest rates on the long end of the yield curve.

Once inflation emerged as a persistent concern in 2021, the Fed shifted its strategy. It eventually ended its bond purchases in March 2022 and began to reduce its more than $8 trillion in asset holdings.

Short-term rates in the broader bond market tend to respond to Fed monetary policy related to the target federal funds rate it controls. The Fed raised the fed funds rate from near 0% prior to March 2022 to a range of between 5.00% and 5.25% by May 2023. Since the Fed shifted its strategy, yields on 3-month U.S. Treasury bills jumped, from 0.01% at the end of 2021 to nearly 5.5% today. The Fed may still be looking to raise rates further, and Fed officials continue to insist they will maintain elevated interest rates for an extended period in an until inflation comes down. Haworth believes that as the Fed sets monetary policy, it’s paying close attention to the impact on the bond market in the hopes of reestablishing a normal yield curve. He points out that the Fed has many tools available to try to influence yields at different maturities in order to effectively achieve its goals of cooling off inflation while avoiding a recession.

Where the economy goes from here

The outlook for the U.S. economy in 2023 has become a bit cloudier in recent months. After growing at a rate of 5.9% as measured by Gross Domestic Product (GDP) in 2021, the economy expanded by just 2.1% in 2022, then slowed to an annualized growth rate of 1.3% in the first quarter of 2023.³ It’s an indication that the Fed’s monetary tightening is slowing economic growth. While the rate of inflation has slowed considerably, from a peak of 9.1% for the 12-month period ending in June 2022 to 4.9% for the 12 months ending in April 2023, it’s still well above the Fed’s targeted 2% rate. The question now is whether the Fed can succeed in its inflation-fighting strategy without pushing the economy into a recession.

Haworth is watching how corporations react to the inverted yield curve. Most companies managed to maintain a strong financial position through 2022, but Haworth says corporate revenue and earnings will be under increasing pressure. “There is less of a payoff from capital spending in the current interest rate environment,” says Haworth. “This could ultimately be one factor driving the economy toward a recession.” Consumer spending is the other important factor affecting the economic outlook. Haworth notes that consumer spending remains solid and given the strength of the labor market, may continue to support positive economic growth.

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