Treasury Yields Invert as Investors Weigh Risk of Recession | U.S. Bank (2024)

An uncommon dynamic known as an inverted yield curve persists in the U.S. bond market. This reflects an environment where yields on shorter-term U.S. Treasury securities exceed the yields on longer-term bonds. It’s an unusual, but not unprecedented occurrence, as investors typically expect to earn higher yields on longer-term bond investments. In addition, some consider an inverted yield curve to be a harbinger of recession. But so far, the U.S. economy continues to exhibit moderate growth with no immediate signs of a recession.

A simple way to view the yield curve is by comparing current interest rates, or yields, on U.S. Treasury securities with maturities of three months, two years, five years, 10 years and 30 years. Investors typically demand higher yields when investing their money for longer periods of time. This is referred to as a normal yield curve, one where yields rise along the curve as bond maturities lengthen. The chart below depicts a normal, upward sloping yield curve among these U.S. Treasury securities of varying maturities, depicting actual yields in the Treasury market at the end of 2021. At that time, the yield on 3-month Treasury bills stood at 0.05% and moved progressively higher as maturities extended along the yield curve, up to a yield of 1.90% on 30-year Treasury bonds.

Source: U.S. Department of the Treasury.

However, at rare times, the yield curve “inverts.” The use of this term does not necessarily indicate that the slope moves consistently higher to lower across the yield spectrum when reading the chart from left to right. But it can mean that yields on some shorter-term securities are higher than those for some longer-term securities.

In late October 2022, the yield on the very short-term 3-month Treasury bill moved above that of the 10-year Treasury note. The inversion has continued since that time.

Source: U.S. Department of the Treasury.

The inversion today is not as steep as it was earlier in 2023. As of December 18, 2023, the yield on the 3-month Treasury bill was 5.46%. By comparison, the yield was 3.95% for the 10-year U.S. Treasury note, a 1.51% spread. The inversion was most pronounced in early May 2023, when yields on 10-year Treasury notes were 1.89% lower than what investors paid on 3-month Treasury bills, but the spread narrowed until recently.¹ The yield on the 10-year Treasury note rose from less than 4% at the end of July to nearly 5% in mid-October, closing the yield inversion gap with 3-month Treasury bills. But 10-year Treasury yields dropped below 4% again in December 2023 as markets anticipated potential changes in Federal Reserve interest rate policy. During that same period, yields on short-term Treasuries were mostly unchanged. “The bond market projects that the Federal Reserve will dramatically alter its interest rate policy in 2024,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “However, the recent steep decline in 10-year Treasury yields shows that the bond market is projecting more rate cuts than Fed officials currently indicate.”

Fed actions are primarily responsible for the yield curve’s inversion. When inflation first emerged as a major issue in 2021 and 2022, the Fed, as a function of its mandate to maintain price stability, increased the short-term federal funds target rate it controls. This is one of the tools the Fed uses to influence the economy. The federal funds rate, which was near 0% in early 2022, was increased 11 times to a range of 5.25% to 5.50% by July 2023. Yields on shorter-term securities followed suit. While longer-term bond yields also moved higher, they didn’t rise as dramatically as shorter-term instruments.

Fading recession risks?

Some market analysts believe an inverted yield curve signals the potential for an economic recession. However, Haworth points out that the reliability of the inverted yield curve as a recession signal is somewhat questionable. “We only have data going back less than 50 years, so the causality connection may not be infallible.” The U.S. economy maintained steady growth since the Fed’s rate hikes began in early 2022, including annualized growth of 5.2% in 2023’s third quarter.² “The most recent pronouncements from the Fed indicate that they believe inflation is mostly under control given the current state of the economy,” notes Haworth. At its December 2023 meeting, Fed officials indicated that interest rate cuts were likely in 2024, a sign that it is close to achieving its goals of taming inflation.

However, Haworth notes the current interest rate environment still creates headwinds for business investment. “It represents a steeper cost for corporations. With short-term rates so high, companies could become increasingly reluctant to borrow, as it is more challenging to realize a payoff when investing the borrowed capital in new equipment and facilities or added employees.” Even though borrowing costs have increased, however, “many corporations are not yet showing signs of distress when it comes to their debt load and continue to maintain strong balance sheets,” says Haworth.

Haworth believes key signals about future economic strength will come down to whether labor market trends reverse and unemployment rises. Recent data shows the unemployment rate remains below 4%, however, still lingering near a half-century low.³ Up to this point, steady consumer spending, buoyed by the strength of the labor market, kept the economy on a growth trajectory. “Consumer spending may slow in 2024,” says Haworth. “But if the Fed follows through with interest rate cuts, it will likely help stabilize economic activity.”

How long will the yield curve inversion persist? Haworth says if the Fed succeeds in maintaining modest inflation and a strong labor market, it will eventually be able to moderate its interest rate policy. “The Fed has pursued two drastically different policies in recent years,” says Haworth, referring to historically low interest rates it maintained prior to 2022, and the rapid increase in short term rates since then. “The Fed hopes to get back to a more neutral stance in the coming year, which should eventually return the yield curve to a normal slope.”

Investment considerations in today’s unusual environment

With yields higher on short-term securities, investors put significant sums to work on that end of the yield spectrum. However, Haworth recommends investors also consider longer-term bonds, with yields that are far more attractive today than they were at the start of 2022. “Investors who kept money out of long-term bonds may want to position assets back toward a more normal allocation into longer-end end of the market,” says Haworth.

One consideration for bond investors is the risk of rising interest rates. When interest rates rise, values of bonds held in an existing portfolio lose market value. “A 30-year bond is much more sensitive to interest rate movements than a 6-month bond,” says Eric Freedman, chief investment officer at U.S. Bank Wealth Management. Yet Freedman believes attractive interest rates create opportunities for investors. “It may be a time for fixed income investors to spread out exposures across the maturity spectrum,” according to Freedman. “It’s also a time to emphasize high credit quality.” Issuers with stronger credit ratings are likely to be in a better position to meet debt obligations should the economy hit any bumps in the road in 2024.

Check-in with your wealth planning professional to make sure you’re comfortable with your current investments and that your portfolio remains consistent with your goals, feelings toward risk and time horizon.

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