What is an Inverted Yield Curve and Why Should You Pay Attention?

What is an inverted yield curve?

Imagine you’re driving and notice a storm brewing on the horizon. You can feel the change in the air, but should you stock up on essentials or is it really just a couple of drops? That’s what an inverted yield curve is for the economy - a warning sign that something might be up. Now be aware, every recession has been accompanied by an inverted yield curve.

So what is an inverted yield curve and why should you pay attention? The yield curve is the relationship, or interest rate spread, between short- and long-term treasury bonds. Normally, short-term interest rates are lower than long-term rates. That is because short-term investors try to price the amount of current inflation while long-term investors want more yield for the risk of lending money long-term. All bond investors worry about inflation.

An inverted yield curve happens when short-term treasuries pay a higher interest rate than long-term treasuries. That’s a bad sign. Why? It means inflation is rearing it's ugly head. The yield curve has been inverted for two years now - you have been feeling that pain! But there is strong evidence inflation is abating.

Why does an inverted yield curve matter?

An inverted yield curve isn’t just a technical term - it’s a signal that we as investors should pay attention to. This isn’t just theoretical, as of August 15, 2024, the yield curve has been inverted for two years, meaning inflation has been sticking around longer than anyone would like. As of August 15, 2024 the 2-year yield to the 10 yield spread was -0.17%, pretty flat, but still negative. For the first time in two years, the 2/30 spread is positive, by 0.10%

We should also know that long-term bonds tend to be more interest-rate sensitive. This means if interest rates drop, you might expect long-term bond yields to fall faster than short-term yields, which is bad for the spread. But we don't want to forget the effect of falling inflation in this equation. At the same time, when yields drop the price of existing bonds rise, which can present opportunities.

How to respond to an inverted yield curve

So what do we do with this information? Nobody has a crystal ball, but we should pay attention to indicators like the yield curve to help inform our investment decisions. You may decide that it's a good time to either take some money off the table, or maybe it makes sense to take some risk off the table. Never make big investment decisions based off of the news or even important indicators without a lot more due diligence. Making emotional investment decisions can have a massive effect on your portfolio, your wealth, and your peace of mind. 

Equities and fixed income tend to respond differently to different economic factors. When stocks rise, bonds may fall, when stocks fall, bonds may rise. If you are able to sell expensive bonds to buy cheap stocks, well that's a great rebalancing opportunity! Although we may make adjustments to our investments based on what is going on in the economy, it is usually better to always be buying. Rising markets? Good, we are buying assets that are going up in value. Falling markets? Hey, I do love a good discount. The time to sell is when it fits into your financial plan.

More to consider

Understanding the yield curve is just one piece of the puzzle. It’s crucial to have a diversified portfolio that can weather different economic conditions. How we respond to the puzzle pieces matter, and at times it is even more important how we DON'T respond. Aside from how we manage our portfolios we also need to be using the right type of accounts and planning for taxes today and in the future. Don't forget to have a plan for how we are going to spend the wealth that we have been so diligent in accumulating. We are not dragons hoarding our gold coins in the mountainside.

Conclusion: The Point of Making Saving Intentional

In the end, it’s about being intentional with your financial planning. The yield curve is a powerful indicator, but it’s not the only one. By staying informed and working with a financial advisor who understands the bigger picture, you can navigate these economic shifts with confidence. At Daley Financial Planning, we want you to have more clarity, less worry about noise, and a plan that works for you—rain or shine. If professional asset management is for you, you can read more at https://www.daleyfp.com/investmentmanagement.

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