Demystifying The Yield Curve's Current Predicament
It's time to talk about the yield curve and the current Treasury inversion
Welcome to The Market Beat! Before we dive in just a quick note that I’ll be out early next week so the next newsletter post will likely be out Wednesday. Cheers!
Demystifying Inversion, And Why Returning To Normal Matters
Every day investors are bombarded with information about difficult and complex topics, and it can be maddening to try and comb through everything to figure out what’s what. The above picture illustrates the massive amounts of noise that traders have been known to pack their screens with, believing that more is always better, as if raw information will suddenly interpret itself if enough of it is jammed in front of their faces.
The yield curve, I think, is one of those things that investors tend to over-complicate. Today let’s discuss the yield curve, today’s inverted yield curve, and why it matters how the yield curve un-inverts.
Even passing readers of financial journalism know from the headlines that an inverted rates curve isn’t a good thing. Fewer understand why. Even fewer understand the fact that how a inverted yield curve returns back to it’s normal, non-inverted self really matters. Like, a lot.
Without insulting anyone’s intelligence here, we’ll start with what the yield curve is. Generally speaking, when folks refer to the yield curve they mean the spread (i.e., the difference between yields) on 2 year and 10 year Treasuries.
For example, a normal yield curve looks like this:
The above chart makes intuitive sense—as the time to maturity extends, the yield rises. If you lend me money for 6 months you’re going to demand (or I’ll be willing to pay) less interest than if you lent me the money for 10 years.
An inverted yield curve, as you might imagine, looks like this:
In this situation, it costs me more to borrow from you for 6 months than for 10 years.
Inverted yield curves are considered to be bad omens. Being paid a higher yield for a shorter maturity only happens (so the thinking goes) when investors expect things to be worse in the near-term than the long term.
This also makes intuitive sense.
Let’s say you’re a short-term lender and businesses come to you for bridge capital. If economic conditions are tightening, and the near-term outlook for these businesses are suddenly more bleak than before, you’re going to demand a higher interest rate.
If you’re a long-term lender and are comfortable with your credit risk, you may not have a problem lending long—but near term worries won’t allow you to jack up the rates you charge (if you do, the borrower will just go somewhere else).
Again, the ‘normal’ state of things is an upward sloping yield curve. The abnormal condition is the downward sloping yield curve.
Those are the basics.
How The Yield Curve Can Normalize (And Why It Matters)
Now, let’s talk about how to apply this theory to the actual market.
Most people will know that the U.S. 2-year and 10-year Treasury curve has been inverted since early 2022. Most people also know the conventional wisdom that an inverted yield curve generally portends tough economic times ahead.
The above chart illustrates the yield on the 2-year Treasury (in white), and the yield on the 10-year Treasury (in blue), and the spread between the two (bottom pane, in yellow) since the start of 2022.
At the start of the chart, things make sense: the 2-year yields less than than 10-year, and the spread (again, the bottom pane) shows a positive value for the spread between the two.
The spread goes on to narrow until July 2022 when it finally turns negative (i.e., the curve inverts), and we’ve been there ever since.
However, the latest data shows that the gap is closing—at the latest reading the spread between the two was only negative 18 basis points, versus almost 100 basis points in July 2023.
Great news! Right?
Well, not so fast.
There are, in theory, two ways that the curve can un-invert. Either:
The 2-year Treasury yield moves down, or
the 10-year Treasury yield moves up.
The first option is known as a bull steepener. This means that the 2-year’s yield is falling, which means that traders and investors believe that the expected near-term pain is less likely to materialize.
This is generally viewed as a positive development for the markets.
The second option is known as a bear steepener. This is when the 2-year stays flat and the 10-year yield goes up past the two year yield, resulting in a restored yield curve at higher overall rates.
This is generally viewed as a negative development for the markets.
The reason for this has to do with the economic outlook. Rising long-term yields against flat short term yields means that market participants believe that things aren’t likely to change in the long-term, and rates for long-term maturities rise to reflect that.
In today’s case, it would mean that traders and market participants are betting that high interest rates will be here for longer. Much longer.
Now, returning to the above chart, we can see pretty clearly that the 2-year hasn’t really budged. The 10-year, however, is a different story.
Only a few days ago the 10-year Treasury took the financial press by storm by hitting an important market—a 5% yield.
This surge is, to put it bluntly, not good. It is a classic bear steepener, and tells us that a large group of generally smart people think that high rates are here to stay for a loooong time.
Great explanation!!