Why the Yield Curve Still Matters, Even When It’s Wrong

Commentary

The yield curve is frequently mentioned in the investment media, and by investment and economic analysts. The yield curve has always been important for fixed income investors but has become an important topic of discussion over the last couple of years since it became “inverted,” in the jargon of Wall Street. This phenomenon has been an excellent indicator of an upcoming recession. However, the yield curve, as defined by the 10-year minus two-year U.S. Treasury spread became inverted in the early summer of 2022. As we head into 2026, there has been no recession.

The fact that the yield curve inversion indicator did not work this time does not lessen the fact that the yield curve is of vital importance to investors. First let’s clearly define what the yield curve is. We may think this is obvious but going back to first principles helps us understand things we sometimes take for granted.

The yield curve is a representation of fixed income securities where the horizontal axis depicts term to maturity and the vertical axis depicts the current interest rate of the different maturities. Most of the time, the curve slopes upward. Short-term instruments usually trade at lower yields than longer-term ones. This makes sense for a few main reasons. One is that the longer an instrument is, the higher the chance the issuer, even the U.S. Treasury, will default. The odds may be low, but we know intuitively that the probability of the U.S. Treasury defaulting overnight is much lower than the chances of a default in the next 30 years. Increased risk requires a higher premium.

Also, we know that inflation risk increases as time increases. A dollar today, will be worth almost the same as a dollar in a few months or slightly less. However, we really do not know what the principal repayment of a 30-year bond will be worth at maturity. Even small differences in inflation are significant. Basically, inflation is an offset to the power of compound interest. For example, a $1,000 principle repayment after 30 years will be worth about $550 in today’s dollars at maturity if inflation averages 2 percent. If inflation averages 4 percent, our $1,000 will be worth only a bit over $300, a bit over half of our lower inflation scenario. At a present yield of a bit over 3.5 percent, the inflation issue is crucial.

The curve is also positively sloped to reflect the interest rate risk of the various instruments. A two-year bond will fall a bit less than two percent in value if its rate rises by 1 percent. By contrast, a 30-year bond will fall in value by almost 20 percent. Of course, longer bonds do much better when rates fall.

Generally, the yield curve is upward sloping and is steep from short-term T-bills to three- to five-year bonds and then increases at a far slower pace as we approach 30 years. Although the curve is positive most of the time, this varies, and the curve is dynamic. Over the last 40 years, the spread between two- and 10-year bonds has ranged from +3 percent to its recent low of -1 percent. Interestingly, the spread tends to trend, affording professional bond managers opportunities. Generally, when the curve is in the process of steepening, the 10-2 spread is rising, a mid term bond will outperform a combination of a short and long term bond weighted for a similar interest rate risk. When curves flatten and invert, the combination of short and long bonds, also called a barbell trade will outperform mid term bonds. Emphasizing the middle bonds is called the bullet trade.

In general but not always, a curve flattening coincides with a bond bear market; a significant sell off in the bond market and vice-versa. Also, the market tends to anticipate yield curve shifts so when the curve is steep and expected to flatten, mid term bonds tend to have higher yield premiums over barbells with similar levels of interest rate risk than when the curve is expected to steepen.

We saw the significance of yield curve shifts in real time from late March 2021 to early July 2023. The U.S. Treasury two- to 10-year spread went from +1.48 percent to -1.08 percent, a massive shift of 256 basis points while rates rose in general. Two-year Treasuries rose from under 0.20 percent to almost 5 percent, while 10-year yields rose from a bit over 1.50 percent to almost 4 percent. Five-year bonds rose from just under 1 percent to over 4 percent but fell in price by the same approximate percentage as 10-year issues at almost 20 percent. Two-year bonds matured at par if they were held until maturity. Owning an interest rate risk equivalent barbell position of two-year and 10-year issues, dramatically outperformed a five-year bullet position. Bonds performed poorly during this period but shortening the average term by selling in five years and buying short-term issues was far better than selling long issues and buying five-year bonds. The reverse dynamic occurs when the curve steepens.

Understanding the yield curve is crucial for investors. Not only does it give us insight into the economic outlook and market sentiment but it provides us with opportunities and risks.

The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.

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