Broker Check

The Yield Curve is Inverting

June 01, 2022

          You may have been hearing some chatter about the yield curve and have no clue what the significance of it may be. Typically, the yield curve represents the difference in interest rates (or yields) on similar bonds based on their respective maturities. In a normal interest rate environment, as an investor in bonds, you would expect a higher interest rate on a 10-year bond, since you have to wait 10 years for repayment of your principal versus a 2-year bond, right? The same is true for a 30-year bond. You would expect a higher yield than on a 10-year bond. Well, recently in April, yields on a 2-year bond rose above yields on the 10-year bond, inverting the yield curve! 

          Marketable bonds, just like stocks, can see price appreciation and depreciation. In other words, if you own a 10-year bond paying a 3% coupon rate, it will eventually mature for $1000 and pay annual interest of $30. During the time you own it, let's say interest rates go up (just like the Fed is now doing to stave off inflation), then newly issued 10-year bonds may pay 4%, so why would anyone pay you the full price of $1000 if you wanted to sell your bond early? It's only paying 3% interest, see? But they may be willing to pay you less, bringing your "current yield" in parity with the new issue bonds. So, as interest rates rise, bond values drop and vice versa. 

          So, now you understand how bond prices can fluctuate, the yield curve offers some insight into how much comparable demand there is for shorter-term, mid-term and long-term bonds. Investors may be selling those 2-year bonds, and piling into the 10-year, driving up demand for the 10-year and driving down the current yield compared against the 2 and 5-year, inverting the curve. This could be a bearish sign, that bond investors feel there may be uncertainty about the economy, and they think intermediate term interest rates may have to go down, at some point, to jumpstart the economy. 

          Though it doesn't seem like a recession is imminent, if the Fed responds too aggressively to inflation pressures, it could slow down the economy and send us into recession. An inverted yield curve may predict a slow-down, that's not always the case. In fact, the curve can remain inverted for quite some time before a slowdown occurs. 

          If you have questions about how this may affect your investments, or retirement plan, give us a call.