Image by Thomas Malyska from Pixabay
Investment volatility remained elevated this year. One can point to any number of culprits. My preferred cause has been interest rate volatility. I’ve been cautious as the Federal Reserve (Fed) raised its benchmark rate. However, a popular risk indicator has recently been sending a mixed message. The yield curve has been steepening. Thus, the investment environment might be changing, requiring different portfolio positioning. Upon further examination, though, I find myself pondering the most dangerous investment thoughts possible: Could this time be different?
As far as investment signals go, it’s hard to beat the shape of the yield curve. It’s one of the most studied and reliable recessionary indicators. While the yield curve’s October 2022 inversion captured much attention, so too has its rapid steepening. However, a look under the hood reveals that it might not be the call-to-action signal for which I was waiting.
Inversions and recessions
Economists have long studied the relationship between the shape of the yield curve and economic performance in the U.S. While specific curve choices vary, they typically compare yields for the 3-month U.S. Treasury bill (3mUST) to the 10-year U.S. Treasury note (10yUST). Normally, this curve is positively sloped, exhibiting a “term premium” whereby longer-dated bonds yield more than shorter-dated ones. However, on rare occasion it inverts such that the 3mUST yields more than the 10yUST. When these occur recessions typically follow making them noteworthy events.
While economists have yet to establish a direct, causal link between U.S. treasury yield curve (USTYC) inversions and recessions, they’ve devised several explanatory theories. One speculates that investors anticipate the dampening effect of high short-term rates on economic growth leading them to bid up (and thus lower the yield for) long-term bonds as higher borrowing costs reduce current investment and consumption thereby
