Amada Agati:  

When the headlines talk about an inverted yield curve, there's rarely a follow-up explaining what that actually means. But it certainly gives a bad news kind of vibe for investors.

In this month's edition of Adding Alpha, we focus on tackling this. What is the yield curve? What does it mean when it's inverted? And what are the implications?

Believe it or not, in business cycle analysis, the shape of the yield curve tends to be an important predictor of what comes next. In quote, unquote normal times, a yield curve should be a smooth line that's upward sloping to the right when graphed.

It plots the yields, or interest rates, of bonds that have equal credit quality but differing maturity dates from three months to two years to five years to 10 years, all the way out to 30 years.

In basic bond market math, the idea is that longer term interest rates should be higher than shorter term rates because it's the reward, or premium, investors should expect to receive in exchange for a longer holding period or duration to maturity.

In the upside down world of inverted yield curves, short-term interest rates end up being higher than long-term rates; and the yield curve is downward sloping.

As of March 31, a three-month T Bill was yielding about 5.4%, whereas a 10-year US Treasury Bond was only yielding 4.3%. That's more than 100 basis points differential. The yield curve has been inverted since about July 2022.

It's quite a long time by historical standards, and it's continued to signal a countdown toward recession. But the yield curve itself does not cause recessions. Think of it as a signal from the bond market that something isn't quite right in the economy.

Houston, we have a problem. And, back in 2022, the Fed was ramping up its most aggressive rate hiking cycle in history.

In other words, the yield curve inverted as a reflection of the Fed's actions, warning us that tightening policy too much could drive the economy into recession if rates went too high and borrowing costs became prohibitively high at the same time inflation was at 40-year highs. Except here we are today with no recession, and the stock market just had one of its best starts to the year in the past 30 years. So should investors ditch the yield curve from the toolbox of business cycle analytics?

The yield curve is an important predictor of recessions but not a perfect predictor, being accurate about 80% of the time since the 1970s. It has given us false positive signals in 1989, 1998, and 2006 when recessions did not ultimately occur after the yield curve inverted. So perhaps this is another one of those times.

Believe it or not, financial conditions are already back to 2021 levels when the world was awash with fiscal stimulus, the Fed was in full blown QE mode, and we haven't had one rate cut yet. The sentiment shift has allowed equity valuations to expand again, driving positive returns in 2024, or at least for that narrow subset of high-quality stocks that can still withstand an elevated inflation backdrop, high interest rates, and a slowing but still solid global growth backdrop.

Even though financial conditions have eased, the yield curve is still inverted; and it continues to put pressure on fixed income investments and interest-rate-sensitive sectors like real estate and financials. So what will it take to normalize policy?

Since three-month T Bill yields track the Fed's policy rate very closely, the Fed could probably achieve at least a flattening of the curve with three rate cuts of 25 basis points each. We do not expect to see a normalized yield curve until sometime in 2025.