The Dow Jones Industrial Average got off to a rough start in December, dropping nearly 800 points in one day alone. One of the primary signals spooking the market was the fact that the yield on five-year Treasury notes fell below the yield on two-year and three-year notes. An inverted yield curve has historically been an early indicator of a U.S. recession, so here’s a rundown of everything traders need to know to be prepared for what’s to come.
What Is an Inverted Yield Curve?
Typically, longer-dated Treasury yields like 30-year yields are higher than shorter-term yields like 10-years. Therefore, a plot of treasury yields over time would create a curve that slopes upward from left to right. However, if investors are fearful that interest rates may fall in the future, longer-dated yields can sometimes dip below shorter-dated yields. This phenomenon is known as an inverted yield curve, which can be seen in the image below.
Inverted Yield Curves and Recessions
An inverted yield curve is notable because it has historically been a relatively reliable indication of a coming U.S. recession. According to the San Francisco Fed, inverted yield curves occurred prior to each of the past nine U.S. economic recessions. The good news is that the yield curve that investors and economists tend to watch most closely is the one between two-year and 10-year Treasuries. While the spread between two-year and ten-year yields is narrower than at any other time since 2007, it has not yet inverted as of this week.
To understand the connection between an inverted yield curve and a recession, you must connect the dots. One of the hardest hit sectors in December has been the financial sector, with the Financial Select Sector SPDR Fund dropping 7 percent. This is because banks take advantage of a positive yield curve to make money.
Banks borrow money in the short-term and use that money to make longer-term loans. The difference between the interest rates on what they borrow and what they lend is how they make profits. When the yield curve is flat or inverted, banks have no financial motivation to lend. When banks lose their incentive to lend, it becomes more difficult for businesses to get the credit they need to grow, and the economy slows down.
If 10-year Treasury yields drop below two-year yields in coming weeks, it could trigger another negative knee-jerk reaction in the market such as the one that occurred on last Tuesday. Historically, the recessions that follow yield curve inversions have happened between 6-24 months after the inversion, with an average latency of about one year.
Most prognosticators have their eyes set on 2019 or 2020 for a potential economic slowdown. Whether you think that’s the case or a bear market is already upon, traders should appreciate the volatility—and the opportunity it brings—for as long as it lasts.
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