The Yield Curve Has Un-inverted, Now What?

Executive Summary

The Treasury yield curve typically refers to the difference between the yield on the 10-year and two-year Treasury Notes. In normal times long-term yields are higher than short-term yields. The Federal Reserve’s recent rate hiking cycle caused the yield curve to invert – meaning short-term rates were higher than long-term. After remaining inverted for 783 days, the longest period in history, it just un-inverted. As seen in the first graph below, this has almost always coincided with the onset of a recession. While the Fed’s anticipated rate cuts could spur the stock market higher, it could also be the catalyst for investors’ flight to safety, as seen during the past three recessions.

Please proceed to read The Details below for more information.

“When you come to a fork in the road, take it.”
–Yogi Berra

The Details

The Treasury yield curve typically refers to the difference between the yield on the 10-year and two-year Treasury Notes. Normally, the yield curve rises because longer-term Notes carry higher rates to compensate for the additional risk involved in holding debt securities for a longer period of time. The yield curve has been particularly consistent in predicting recessions. When the yield curve inverts, short-term yields become higher than long-term yields. The Federal Reserve Bank, through the use of Monetary Policy, controls short-term yields. Long-term yields, on the other hand, are determined by supply and demand for longer-term notes.

When the Fed is concerned about inflation rising and the economy overheating, they raise short-term rates. As this happens, investors often move funds into longer-term notes and bonds fearing a slowdown in the economy. When it becomes more apparent a slowdown is coming, the “flight-to-safety” trade – or buying long-term Treasuries – picks up steam. This flight-to-safety pushes bond prices higher and yields lower. When the Fed believes they have intervened enough to slow the economy and become concerned they could dampen future growth with further hikes, they stop raising rates. When they fear the economy has exhibited signs of slowing too much, they will begin lowering short-term rates. As short-term rates fall, the yield curve un-inverts. Recessions are usually ahead when this occurs.

Notice in the graph below, from the St. Louis Fed FRED database, when the yield curve has un-inverted, the economy was either in – or soon to be in – a recession.

Over the years, the Fed has become more active in “attempting” to control the economy. Their timing with Monetary Policy is often too late or too early. The yield curve recently un-inverted after remaining inverted for 783 days, the longest period in history. The second longest period of inversion was just prior to the Great Depression in 1929, when the curve was inverted for 700 days.

Normally the stock market loves low interest rates. The record bubble in the stock market was produced from the insane zero-interest rate policy of the Fed. In October 2023, the Fed announced a “pause” in interest rate hikes. Investors got way ahead of themselves, pushing the market (and valuations) sky-high. The theory behind the exuberance was investors were anticipating upcoming Fed rate cuts. It is pretty much settled among market participants that the Fed will begin lowering the Federal Funds Rate on Wednesday this week, at the end of their FOMC (Federal Open Markets Committee) meeting. The estimate is for a 0.25 percent cut this week, with continued cuts this year and into next.

Some investors believe that these rate cuts will spur more speculative behavior, sending the stock market higher. And that is a possibility. However, the graph below shows that when the Fed began lowering rates at the end of the Tech Bubble, Real Estate Bubble and Pandemic, a recession ensued and a plunge in the stock market followed. The only difference occurred during the Pandemic when the Federal Government, in cahoots with the Fed, dumped a record amount of stimulus into the economy reversing the market plunge and eventually leading to rapid inflation.

The mere fact that the Fed is ready to begin rate reductions reveals their fear the economy is slipping towards a recession. Absent another massive infusion of government funds – at the risk of reigniting inflation – will the stock market cheer lower rates? Or will the market plunge as it has historically? Stocks are massively overvalued, just as before the prior crises, and the economy is weakening. The Fed cutting rates could be the signal for investors to flee-to-safety.

The S&P 500 Index closed at 5,626, up 4.0% for the week. The yield on the 10-year Treasury Note fell to 3.65%. Oil prices increased to $69 per barrel, and the national average price of gasoline according to AAA fell to $3.21 per gallon.