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What Is the Inverted Yield Curve, and What Does It Mean for the Economy?

By Brittany N. Cox,
Registered Investment Advisor at Nestlerode & Loy Investment Advisors

There have been some turned heads this week about the inverted yield curve. Some of you may be asking what is an inverted yield curve? It is a phenomenon in the bond market in which longer-term interest rates fall below shorter-term interest rates and has historically been a warning sign that a recession could be on the way. 

When you think about the money in your checking account at the bank, you have instant access to this money, therefore the bank doesn’t pay you much interest, if any. However, if you lock it up for a year or more, the bank will offer you a higher rate of return for your money while you lend it to the bank. For U.S. government securities, known as Treasury bonds, that relationship has now turned upside down. As of Wednesday morning, the yield on the 10-year Treasury temporarily fell below the yield on the two-year Treasury for the first time since 2007. 

For those who are in tune with investing and the bond market, this all seems obvious. However, it can be completely perplexing to those who are not. The New York Times article “What’s the Deal with That Inverted Yield Curve?” on Thursday had an intriguing analogy, tying bonds and interest rates to the performance of NFL teams. I’ll shorten it up for you. 

Think of it like this: You can walk into a casino and bet on the Steelers winning nine games this season. But, imagine betting on the Steelers winning nine games this season, and their performance over the next two, five, and 10 years. In this situation, you would pay an up-front premium for a ticket that would pay you, say, $15 for every regular season win they have for the next 10 years. You could then sell your ticket, if you choose, to other bettors while the price will rise and fall with the feelings toward the Steelers’ performance. This resembles the bond market in the sense that bonds which mature at different times are trading on the market and based on investors’ feelings about the rates, their prices rise and fall. 

Interest rates are closely connected to the rate of economic growth and inflation. When the economy is doing well, more people want to borrow money for things like new homes and to expand their businesses. During these times, the Federal Reserve will raise the interest rate to prevent the economy from overheating, resulting in inflation. The Fed lowered its rate in July and strategists are predicting more in September. The last easing cycle of the Fed occurred 11 years ago in the run-up to the financial crisis in 2007. 

So, back to our sports analogy, if you buy a 90-day Treasury bill, you are likely to receive a rate that is close to the Fed rate. This is like betting on the upcoming weekend’s game. You know the opponent, you know how they performed last week, you know how your team performed last week, and you can make a pretty solid prediction based on any injuries and news that came out this week. However, if you buy a 10-year note, you’re betting long term. The economy will likely change more during that term. You can’t predict what will happen that far out, but you can try to predict the general direction. If you’re betting on a young team who just drafted a quarterback from the first round, you may not want to purchase a short-term ticket for that team, but a long-term ticket looks intriguing. 

However, a team like the Patriots with a 42-year-old quarterback would probably have a higher premium for a short-term ticket versus a long-term ticket. This is what the yield curve is up to. Our Patriots ticket yield is inverted just like the Treasury bond yield curve was on Wednesday. This has investors spooked as you have seen in the market the past few days.  That is because the yield curve has inverted before every U.S. recession since 1955, however it sometimes happens months or even years before the recession starts. It’s also important to remember that recessions can happen during a secular bull market. It’s important to pay attention and stay in touch with your financial advisor to be sure you are comfortable with your investment plan.