The Yield Curve Has Inverted. What Does That Mean? - Barron's

Photograph by Clem Onojeghuo

All three major U.S. stock market indexes took a downturn on Friday, as investors responded to one of the key recession indicators: the so-called inversion of the yield curve between the 10-year and three-month Treasuries.

The Dow Jones Industrial Average and the S&P 500 were each down about 1.5% near midday, while the Nasdaq was off almost 2%.

The yield curve is the difference between the yields on longer-term and shorter-term Treasuries. A yield curve inversion happens when long-term yields fall below short-term yields. It has historically been viewed as a reliable indicator of upcoming recessions.

Why? While the short-term side of the yield curve is mainly driven by Federal Reserve policy that reflects current economic strength, the long-term end of the yield curve—10-year Treasuries and further out—is thought to indicate bond investors’ long-term views of the market.

If bond investors are bullish on the economy and believe interest rates will go up, they are more willing to hold short-term bonds and hope to harvest the higher yields later on. On the flip side, if bond buyers believe the economy is heading downward and interest rates are likely drifting lower, they’d prefer to hold the longer-term bonds in order to lock in the current higher yields.

In that case, the higher demand for longer-term bonds will drive up their prices and lower the yields. Yields on long-term bonds are usually higher during economic expansions because bond investors need more compensation to be locked in. But when the sentiment gets too bearish, the long-term yields can fall below the short-term yields.

That’s what’s happened Friday.

Experts are split on which yield curve is the most reliable, but the Fed prefers looking at the curve between the 10-year and three-month Treasuries, which on Friday turned negative, to minus 0.196 percentage points.

While a yield curve inversion has preceded recent recessions, it doesn’t happen immediately, and the lead time has been very inconsistent. Historically, a recession can come anywhere from one to two years after the curve flips upside-down, and the stock market usually continues to gain from the day of the inversion until its cycle peak.

So we’ve got more time to watch.

Write to Evie Liu at evie.liu@barrons.com

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https://www.barrons.com/articles/yield-curve-inversion-51553272263

2019-03-22 17:31:00Z
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