Inverted Yield Curve (4/2/2019)

You may be hearing more these days about U.S. Treasury Bills and the inverted yield curve.

What is an inverted yield curve? Normally, as a bond investor, you are paid more for bonds that have longer maturities. For example, you would expect to get a higher interest rate on a 10-year bond than on a bond that will mature in 90 days. The reason is the risk factor. You will be getting your money back on the 90-day bond in 90 days, while on the 10-year bond, you will not see your principal returned for 10 years.  Because U.S. Government bonds, notes and bills are considered the safest investments, they tend to pay less interest than corporate or municipal bonds. The 10-year U.S. Government bond, in particular, is closely watched because it is used as a standard in determining the interest on other investments, such as mortgages. Recently, the yield on the 10-year bond has gone down and mortgage interest rates have followed suit. The question is: Can the inverted yield curve be important to investors? 

An inverted yield curve occurs when the interest on the shorter duration bonds, such as the 90-day Treasury Bill, is paying a higher interest rate than bonds that mature in 2, 5, or 10 years. At the close of business yesterday, March 27, the 90-day bill was paying 2.42%, the 2-year note was paying 2.21%, the 5-year bond was paying 2.16%, and the 10-year bond was paying 2.38%.  This means that as an investor, you are being paid more for buying short term Treasuries, rather than those with longer durations.

A predictable harbinger of equity market corrections has been the inverted yield curve. Economic contractions in gross domestic product (GDP), since 1977, have followed a period of the inversion of the yield curve.  The timing of the decline in the GDP is usually between seven to 10 quarters after the inversion. Currently, the 2-year note is still paying 0.18 less interest than the 10-year bond. These are the two interest rates that are generally used when looking at an inverted yield curve that could mean a reduction in GDP. We are not there yet, but as you can see with the 90-day bill, the yield on the bill is paying a bit more than the 10-year bond.

Why is this so important? This difference has a big impact on business. Perhaps the easiest way to explain this is to look at banks that use deposits from short-term savers to lend money to mortgage borrowers long-term. The way banks make money is by paying the saver less than they charge for the mortgage. If banks must raise rates for savers to bring money in, then the short-term cost of borrowing can become higher than banks can get by lending the money to mortgage borrowers. To help offset this, banks raise credit standards, making it harder to get a mortgage. Currently, we are seeing banks advertising higher savings rates for products like CDs and becoming stricter on credit standards.

The Fed has said it is not going to raise rates again for a while. There has even been talk of lowering the discount rate. If the Fed doesn’t raise rates or eases up on the discount rate, interest rates will possibly not become inverted.  Regardless, we need to watch this closely and realize we could be seven to 10 quarters away from a downturn in the economy.

Ed Mallon

April 2, 2019