On Monday, December 3, the U.S. Treasury Yield Curve inverted for the first time in over a decade. Just one day later, the Dow fell 799 points (3.1 percent), with the S&P 500 and Nasdaq also finishing down (3.2 percent and 3.8 percent respectively).1
The yield curve inversion occurred as the yield on the five-year note hit 2.83, one basis point lower than the three-year note’s yield of 2.84. (If you’re not familiar with basis points, 100 basis points equals one percent. One basis point equals .01 percent.)
What exactly is the U.S. Treasury Yield Curve and how does its inversion affect investors? The Treasury Department sells 12 types of securities: bills in durations of one, two, three and six months; Treasury notes in durations of one, two, three, five and 10 years; and 30-year bonds. A yield is the return an investor realizes from a fixed-income security, which includes the 12 securities offered by the U.S. Treasury.
In a growing economy, the longer the maturity of the security, the higher its yield. This is due to its duration risk; the longer the security is held, the more sensitive it is to interest rate changes. A yield curve shows the spread between yields for each type of security. The yield curve is normally an up-sloped shape, somewhat like a capital U.
When shorter-term security yields surpass long-term security yields, the yield curve turns upside down. The inversion is caused by predicted interest rates; if interest rates are forecasted to be lower in the future, investors purchase more long-term bonds in order to lock in their higher rates now. In response to the increase in demand, the price for long-term securities goes up and yield goes down. The opposite is true for short-term securities, where yields are being pushed up due to decreased demand. The curve changes shape as the relationship between short-term and long-term yields changes.2
An inverted – or negative, as it’s sometimes called – yield curve is often a predictor of a lurking recession; the yield curve has inverted ahead of the past seven recessions. However, while the inversion often accurately predicts a turning point, a recession doesn’t always follow immediately on its heels. For example, the yield curve inverted in March 2006, and the first pangs of the following recession weren’t felt until December 2007.3
Even though there is frequently a gap between an inversion and a recession, some analysts are tying Tuesday’s market drop to investors who are nervous about the inverted yield curve.4 Although we can’t say for sure if this is a turning point in the current business cycle, the inverted yield curve tells us that investors aren’t optimistic about the economy in the near future.
1 Matt Egan. CNN Business. Dec. 4, 2018. “Dow plunges 799 points on trade, slowdown fears.” https://www.cnn.com/2018/12/04/investing/stock-market-today-dow-jones/index.html. Accessed Dec. 5, 2018.
2 Investopedia. “Inverted Yield Curve.” https://www.investopedia.com/terms/i/invertedyieldcurve.asp. Accessed Dec. 5, 2018.
3 The National Bureau of Economic Research. “US Business Cycle Expansions and Contractions.” https://www.nber.org/cycles.html. Accessed Dec. 5, 2018.
4 Kevin Kelleher. Fortune. Dec. 4, 2018. “An Inverted Yield Curve, a Predictor of Recessions, Has the Stock Market Spooked. http://fortune.com/2018/12/04/stock-market-inverted-yield-curve-are-we-in-a-recession/. Accessed Dec. 5, 2018.
This content is provided for informational purposes only. The third-party information and opinions contained herein, have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by AE Wealth Management.