Yield Curve Inversion and Un-Inversion: What It Means

Those who rely on financial markets for their business, livelihood, or both, should take a close look at what is happening with a classic recession indicator. 

For decades, the spread between the yield on 10-year U.S. Treasury bonds and two-year U.S. Treasury notes has been the Paul Revere of recessions, warning of approaching economic downturns. 

When the yield “inverts” and then “un-inverts” a recession is close at hand. This has been the case with the past six U.S. recessions going back to 1976. And recent price action in the bond market has the U.S. poised for number seven. 

In a normal market, we’d expect yields to be higher the longer your money is loaned to the borrower. In the case of U.S. Treasuries, the borrower is the U.S. government. But a combination of concerns has recently caused the most inverted yield curve since 1981, with two-year notes recently yielding more than 1 percentage point more than 10-year bonds. 

Treasury Yield Curve Inversion, Un-Inversion and Recession

But from that situation at the end of June 2023, the 10-2 Treasury spread has closed sharply, sitting at 0.34% as of Tuesday’s market close. A combination of culprits has been identified by market watchers, from the Federal Reserve holding rates “higher for longer” to chaos in Congress, and from some of the biggest holders of U.S. Treasuries, such as Japan and China, needing to sell U.S. bonds to aid their home currencies.  

Even if the “R” word doesn’t enter the picture for a while, there is a big difference between two- and 10-year Treasuries yield 4.8% and 3.8% respectively (the case at the end of June), and the current situation, at 5.1% and 4.7%.  

For advisors, this is a portfolio positioning and communication issue in two parts. High-net-worth investors tend not to be “all in” on the equity market, and so the bond market, which has been moribund for the better part of 15 years, is suddenly a focus point for them. Depending on how advisors decide to invest for their clients in this suddenly new era of bond investing, a couple noted below might be a consideration in the research process. 

Treasury ETFs to Consider 

While the iShares 20+ Year Treasury Bond ETF (TLT) has become somewhat iconic during the bond market’s return to relevance since last year, this $37 billion ETF is a popular trading vehicle for exchange-traded funds and option traders. So, its cousin, the iShares 10-20 Year Treasury Bond ETF (TLH), may be a consideration for those seeking to position for a stabilization of or decline in longer-term Treasury rates.  

As the name implies, TLH starts at the 10-year maturity point, though currently its holdings are focused (93%) in bonds maturing in 15 to 20 years. TLH is also quite liquid, with assets of $6.6 billion and a daily average trading volume of $96.5 million. Over the past year, with bond prices fading, TLH has lost 10.3% versus the more volatile TLT’s loss of 15.4%, a significant difference. 

While TLH may be attractive to current fixed-income bulls, bond bears may take an interest in ETFs that aim to profit from continued rising rates. The FolioBeyond Alternative Income & Interest Rate Hedge ETF (RISR) is a smaller fund at $69 million in assets, but its unique approach has spurred an 12% gain so far this year. RISR targets a duration of 10 years, but in the opposite direction. In other words, it aims to perform well when long-term rates rise, and will likely decline when those rates fall. 

Eye on the Bond Market 

In the final quarter of 2023, investment advisors need to keep an eye on the bond market, even if they primarily focus their investing on the stock market. And one of the key indicators of where the bond market is going, as well as the economy, is the 10-2 U.S. Treasury spread.