Inverted yield curve
In certain special circumstances, notably before an economic recession, long-term yields tend to be lower than short-term yields. This happens when investors expect a sharp slump in economic growth, low inflation, and a subsequent rate cut by the Fed.
For 122 trading days out of 251 in 2000, the yield on three-month T-bills was higher than the yield on ten-year notes. On December 14, 2000, the spread between the three-month T-bill and ten-year note was the lowest, at -83 basis points (1 basis point is 0.01%). The inversion was followed by economic recession from March 2001 to November 2001 fuelled by the Dot Com burst.
As an inversion of the yield curve is typically followed by an economic downturn, investors should look for signs of the yield curve inverting. If the long-term yields start falling on a sustained basis while short-term rates stay intact, an inverted yield curve may be in the cards. As the yields on longer-term securities are lower than the yield for short-term securities, they tend to be overpriced relative to their short-term counterparts, as price and yield share an inverse relationship. So investors should move out of medium-term Treasuries (IEF) and long-term Treasuries (TLT).
As an inverted yield curve will most likely precede an economic recession, the most appropriate response from the Fed would be to lower interest rates in order to boost consumption growth. So short-term Treasuries (BIL) provide an attractive investment proposition, as their prices should rise in response to rate cuts by the Fed.
As commercial banks such as JP Morgan (JPM) and Wells Fargo & Company (WFC) generally borrow short-term and lend long-term, they tend to be at a loss when the yield curve inverts. As short-term rates are higher, these banks end up paying higher interest to their depositors than what they make through lending. So investors should offload banking stocks on signs of an inverted yield curve.
To learn more about the humped yield curve, read on to the next part of this series.