A flattening yield curve is causing a lot of the financial press to write about the most reliable recession predictor in the world, but is there reason to worry?
First, let’s go over the basics. A yield, of course, is the income that an investment pays the investor–so a U.S. Treasury bond that matures in 10 years currently pays 2.48% interest per year.
That’s a long time, which is why a lot of investors prefer bonds with a shorter duration, such as the 2-year Treasury. That preference means 2-year Treasuries yield more most of the time–but now they yield 2.30%, or just 18 basis points less than the 10-year treasury.
In normal times, the gap between the two will be wider, but investor caution and a negative outlook can make that gap smaller–until times when the market is really nervous, and the 10-year Treasury yields less than the 2-year. That’s known as an “inverted” yield curve, and we’re closer to that point than we’ve been since 2019, shortly before the last recession.
Of course, the last recession was caused by a once-in-a-century pandemic, so it’s hard to say the inverted yield curve there really predicted an economy poised for collapse. But in 2006 when the same thing happened, there were more signs of an eminent structural downturn–house prices were hitting unsustainably high levels, borrowing costs were rising, and way too many Americans were overleveraged.
And now, many people are seeing the same exact concerns on the ground.
As a result, bond traders are beginning to bid down long-term Treasury yields to the point where 2-year and 10-year bonds yield very close to one another, and if the trend continues we could see investors getting paid less for keeping their money locked up in Treasuries for longer. That’s obviously crazy, which is partly why it spells recession and is such a reliable indicator that something is wrong with the markets and needs to be corrected.
Another problem with inverted yield curves is that they provide little room to hide. While economic downturns encourage investors to flock to safe-haven assets like U.S. Treasuries in the short term, over the long term those Treasuries perform poorly as the need for a safe haven diminishes. Hence buying a bunch of Treasuries before the last yield curve and holding them throughout the COVID-19 driven pandemic led to a really poor result, but buying them in the short-term gave some outperformance. Large institutional investors will try to oscillate between being overweight and underweight these two asset classes in an attempt to get them at the best price and provide the best returns and liquidity for the current market conditions–more Treasuries for income and capital gains potential in downturns, more stocks for capital gains potential in upturns.
There are alternatives such as corporate bonds, preferred stocks, and other assets that are less volatile than common stocks but riskier than Treasuries. During that short window when things get scarier and scarier (i.e., when the recession is just starting), the market will move from stocks to corporate bonds and preferred stocks to Treasury bonds in a flash, making Treasuries outperform. Similarly, during that short window when things go from scariest to looking better (i.e., the middle of 2020 when the Federal Reserve stepped in, economies partially reopened, and signs of an effective vaccine were appearing), markets will whiplash back to common stocks. In between those two, preferred stocks and corproate bonds are a stopover towards those two destinations–which is why they tend to do very well when the yield curve is just starting to invert.
What this means is that investors in all funds will be looking at not just what stocks and bonds to buy compared to other similar stocks and bonds in the same asset class, but how much allocation there should be to entirely different asset classes. This becomes more of a macroeconomic question than one of fundamental investing, again frustrating for those in the financial world who focus on fundamentals first and foremost. These kinds of dynamics don’t tend to last long, however, so fundamentals will likely return after there’s been some resolution as to where the yield curve is going. Until then, though, fundamentals are likely to stay on the sidelines.