You’ve likely heard about it in the financial press recently: this ominous, notorious thing called the “yield-curve inversion.” Should investors be concerned about this event? And why are analysts, pundits, and traders—and even the US president—so obsessed with yield curve inversions, anyway?

A clear-minded examination of what the yield curve is, how it might impact the equities markets, and what it means for you as a trader can help you parse financial news developments. This understanding can also help you act accordingly—if that’s even necessary.

Strange days in the bond market

When you buy a US Treasury bond, you’re basically loaning your money to the government for a specified period. Or you could look at it another way. The government is safely storing your capital in case the stock market and the value of the dollar crash. Traditionally, the government will reward you for entrusting it with your money by paying a distribution.

Back in the old days when I was young, the annual yield on a ten-year Treasury bond was around 5%. This yield was less than the stock market’s average return of 8% per year, but it carried less risk. (They call bond yields the “risk-free rate,” after all). Nowadays, 5% annual returns on a ten-year Treasury bond are entirely out of the question. Federal Reserve Chairman Jerome Powell briefly raised the rate to 3% in the fourth quarter of last year. As a result, the stock market had a hissy fit. It dove 20%.

As I write this, the ten-year Treasury yield is a mere 1.528%. The US inflation rate is 1.8%, so the “real” (post-inflation) rate is actually less than zero. That’s pretty bizarre, but it gets even weirder. On August 14, the ten-year bond yield was so low that it was exactly the same as the two-year bond yield. This is known as a “flattening of the yield curve” because of the way it’s represented on a line chart.

That same day, the yield curve actually “inverted,” meaning that the ten-year yield was less than the two-year yield. This is a highly unusual phenomenon since a two-year loan of your money to the government theoretically shouldn’t pay you more than a ten-year loan. Other yield curves had already inverted prior (including the three-month and ten-year yields, if you can believe it). But the ten- and two-year spread is the most widely and closely watched.

What does the yield curve inversion mean?

Some analysts view the bond market’s unwillingness to commit to a ten-year loan to the government as a bad sign. It could indicate that they’re not confident in the government’s ability to handle its business. In other words, people are looking to make short-term loans because they have a pessimistic long-term outlook on the US economy. It’s been said that the bond market is always smarter than the stock market, so a euphoric S&P 500 near all-time highs and a fearful bond market could, indeed, indicate trouble ahead. The S&P 500 ETF (SPY) is up almost 14% year-to-date as of Friday’s close. Meanwhile, the iShares 7-10 Year Treasury Bond ETF (IEF) is up almost 9%. 

Knowing that ten- and two-year yield curve inversions preceded the last two economic recessions, the stock market plunged on August 14 with the S&P 500 (SPY) taking a 3% haircut. None too pleased with this fall, President Trump tweeted, “CRAZY INVERTED YIELD CURVE! We should easily be reaping big Rewards & Gains, but the Fed is holding us back.” Trump also allegedly called Jamie Dimon, the CEO of JPMorgan (JPM), as well as the CEOs of Bank of America (BAC) and Citigroup (C) that day.

Soon afterward, the ten- and two-year yield curve un-inverted. But then it inverted again on August 22. At 4:05 PM ET that day, the two-year Treasury yield was 1.614% while the ten-year yield stood at 1.611%. By the time this post is published, the yield curve might be inverted, flattened, or un-inverted (that is, “normal”).

A very close call

That’s a big part of the market’s fascination with the yield curve. It’s a very close call at this point, and too early to tell whether or not it will stay inverted. If it stays inverted for months at a time, some analysts would consider that to be a likely market crash indicator. And, with the Federal Reserve possibly seeking to slash the ten-year bond yields even further in the near future, the warning signals could be flashing sooner than anyone had expected. 

As of this writing, David Moadel did not hold a position in any of the aforementioned securities.

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