On April 1, 2022, the bond market made headlines, and not in a good way.
The 2-year Treasury note closed that day earning 2.44% per year for the next 2 years. And the 10-year Treasury bond closed that day earning just 2.39% per year for the next 10 years. Thus, an official “yield curve inversion” began.
A yield curve inversion occurs when short-term interest rates rise above long-term interest rates. This is unnatural in the financial markets as typically a longer-term Treasury should earn a higher return due to the additional risks (primarily inflation) that come with owning a bond over a longer period of time.
Based on media reports at the time, one could have reached the conclusion that this budding yield curve inversion indicated a recession was absolutely imminent in the near future. Historically, there is some justification for such apprehension as yield curve inversions have indicated a heightened risk of recession over the following 6-18 months.
Stock market traders responded accordingly and took stock markets into a bear market over the next few months.
However, not every yield curve inversion has preceded a recession and not every recession has been preceded by a yield curve inversion.
On August 28, 2024, the 2-year Treasury note closed earning 3.83% per year. And the 10-year Treasury bond closed earning 3.84% per year. Thus, the official “yield curve inversion” ended. You may not have noticed the complete lack of media coverage for this uninversion.
While the markets appreciate it when longer-term Treasury yields are higher than shorter-term Treasury yields, we are not out of the woods quite yet.
First, the shortest-term Treasury bills that mature in one year or less are still yielding significantly more than the 10-year Treasury. This is still unnatural, but should migrate toward normalcy as the Federal Reserve starts to reduce its target interest rate later this month.
Second, an uninversion does not erase the fact that there was a yield curve inversion. The last non-pandemic recession that started in November 2007 was preceded by a yield curve inversion that lasted from December 2005 to June 2007. The recession started five months AFTER the yield curve uninverted.
While the yield curve uninversion is certainly a step in the right direction toward economic and market normalcy, the end of 2024 and the beginning of 2025 are the most likely timeframe for a recession to begin if we are heading down that path.
Regrettably, despite decades of experience, we are unable to predict the economic or market future with any degree of accuracy. Thus, we must always be prepared for the “unexpected” every day of every week of every month of every year by maintaining risk-appropriate portfolios aligned with our clients’ financial goals and cash flow needs.
Quote of the week: Howard Marks: “There is simply no place for certainty in fields that are influenced by psychological fluctuations, irrationality and randomness. Politics and economics are two such fields, and investing is another.”
Graphic Credit: iStock-1447652910
