What Is the Yield Curve Telling Us?

The U.S. Treasury yield curve represents the term structure of interest rates for the world’s lowest risk bond. As the U.S. government can print its own money, it should never be unable to pay off its debt. The recent debt ceiling debates in Congress have raised concerns not about our government’s ability to pay its debt, but rather its willingness. However, U.S. government securities remain the go-to “risk free” asset, and its yield curve is the most official reflection of bond market expectations for interest rates, inflation and economic growth.

The yield curve reflects bond investors’ decisions on maturities based on their outlook for interest rates and the interactions between the various players in the bond market. There are several theories that attempt to explain why yield curves have the shapes they do. The most touted explanation is that the yield curve simply reflects the bond market’s current forecast of future interest rates. That is, the 10-year Treasury bond represents the bond market’s forecast of the 1-year Treasury rate each year over the next ten years. This is known as the “Expectations Theory”.

Market expectations get reflected in the yield curve particularly when comparing short-term rates to long-term rates. A common comparison is between the 2-year Treasury yield and 10-year Treasury yield, also known as the “term spread.”

This chart reflects the “normal” yield curve as determined by taking the median yield at each maturity over the last 40 years. Over that period, the 10-year yield has been a median 0.62% or 62 basis points higher than the 2-year yield.

That implies that bond markets “normally” expect interest rates to rise over time if the Expectations Theory is correct.  Most believe it is probably also reflecting a “term premium,” meaning investors see some risk in locking in a rate for 10 years due to liquidity and the risk of inflation, and thus require a higher rate at 10 years than at 2 years.

The question becomes, what is the bond market indicating when the spread between the 10-year yield and 2-year yield is radically different that 62 basis points? For example, in July of 2023, the spread was a negative 108 basis points after being as wide as 159 basis points in just March 2021. The negative 108 basis points is the widest negative spread we have had since September of 1981.

In 1981, bond investors were comfortable locking in lower long-term yields because they expected inflation to be brought under control and for short-term yields to fall quickly. And this is exactly what happened. The 2-Year Treasury yield dropped from 16.8% in September 1981 to below 8% by December 1985 as inflation was brought under control and the Federal Reserve was finally able to reduce short-term rates.

What was the July 2023 yield curve telling us about bond market expectations? A negatively sloped yield curve is traditionally interpreted as the bond market’s expecting a slower economy causing the Federal Reserve to eventually lower short-term rates. This is the “hard landing” scenario where the Federal Reserve goes too far in trying to bring inflation down such that they cause a deep recession.

Many have noticed that while the yield curve is still negatively sloped in October 2023, the slope is much less negative in October (minus 36 basis points) than in July. Does this mean the risk of recession has eased? Remember that in the early 1980s, the term spread went from negative to positive because short-term bonds rallied (that is, their yields fell). While both 10-year and 2-year yields fell, the 2-year yield fell much more pushing the term spread from highly negative to highly positive, to over 100 basis points positive as quickly as October 1982. This “steepening yield curve” caused by short-term rates falling is great news for investors.

Unfortunately, that is not the case in October 2023. The spread did not go from minus 108 to minus 36 because short-term yields fell but because long-term yields rose as those bonds continued their historic sell off. This is known as a “bear steepener” because the yield curve is reflecting a bear market in long-term bonds, not a bull market in short-term bonds. This is usually bad news for investors.

According to a recent article in The Economist, over the last 40 years, there have been three times when negatively sloped yield curves experienced a bear steepening – 1990, 2000 and 2008. Those were not great times for the U.S. economy with the S&L crisis in 1990, the dot.com crash in 2001 and the financial crisis in 2008. Bond markets are usually unhappy for good reasons!

Regardless of the omen of this bear steepening, there is no question sustained higher interest rates will be bad news for borrowers, including for home mortgages, corporations and countries, like the U.S., with unusually high debt levels. There is likely to be some more pain from this current interest rate cycle as borrowers begin to fully realize the impact of higher interest costs on their overall financial health.