What an Inverted Yield Curve Means

If it looks like a recession, smells like a recession, and sounds like a recession. Then it probably is a recession. Not all things have to come together at once to cause a recession. That last two major recessions it did, but that doesn’t mean a global financial crisis and a pandemic are the norm.

The yield curve has been meaningfully inverted for some time. And when I say meaningfully inverted, I mean to levels we have not seen for a long time.

What this chart indicates is that investors are more worrisome about the short term then they are about the long term. Investors are selling, pushing up the yield on the short term Treasuries, and buying the longer term Treasuries, pushing the yield down.

What that meant in 2022, because bonds fell in value across the board, was that there were  marginally less sellers of long term debt than short term debt.

The yield curve is about the best forecaster we have for recessions, in all of history it has never been wrong, yet. That can change because it is a sentiment indicator of sorts. People move the markets, markets don’t move on their own. So people are the ones inverting the yield curve, they are the ones getting worried about the short term.

We all know that recessions are bad for business and for the economy. Naturally because recessions are bad for business, it’s also bad for the stock market.

But what’s strange this time is usually the stock market falls after an inversion in the yield curve. This time around the stock market bottomed before the yield curve even started to invert.

That sounds like a bullish sign for the future, but now the yield curve is inverted so much that it’s really hard to tell.

The steepness of the inversion doesn’t actually tell us anything about the severity of a recession. In 2008 the yield curve didn’t invert too drastically, yet that was one of the worst recessions since the Great Depression.

Two reasons why I think we’ve seen such a steep inversion.

1. The Fed has been so transparent on the future of policy coupled with the already existing market expectation that rates were going higher.
2. There has never been a call for a recession in history like we’ve seen this past 2 years.

I think the steepness of the yield curve signals the confidence of market participant’s expectations around the future.

When everyone is on the same side of the boat, they tend to start moving to the other side.

That is what we’ve seen in the stock market in 2023 with 20% move higher.

I find it hard to imagine the yield curve inverting more. That said long term rates must move higher or short term rates must move lower.

How this happens is a recession hits that causes the Fed to reverse policy, or inflation and growth continue which keeps terminal rates higher and long term bonds creep back upwards.