The yield curve between the 2-year and 10-year Treasury notes has continued to invert with the spread between the two now deepening to its most significant level in more than 22 years.
Early Friday, the spread between the U.S. 10-year Treasury yield (US10Y) and the U.S. 2-year Treasury yield (US2Y) touched -55 basis points. In early action trading, the 10Y was down 7 basis points to 3.88 percent while the 2Y fell 4 basis points to 4.41 percent, Seeking Alpha reported.
Treasury notes, bills, and bonds are debt instruments from the U.S. government that are generally considered among the safest investments. Investors use the 10-year Treasury yield to indicate investor confidence.
Factors that can affect the interest rate of bonds and change the yield curve include investor confidence, Federal Reserve policy and inflation.
As investors lose confidence in the market, they offer lower bids on safe investments such as Treasuries. The Federal Reserve can also influence interest rates by adjusting benchmark interest rates, like the federal funds rate. If the Fed boosts market rates, it can cause an increase in bond rates, too. Inflation can also play a role. During periods of high inflation, investors will demand higher interest rates to ensure they receive similar returns in real terms.
When investors are confident in the market, rates rise because fewer people want to buy bonds. When confidence is low, rates will drop as more people flock to bonds, Forbes reported.
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An inverted yield curve, which graphically shows that long-term interest rates are less than short-term interest rates, has proven in the past to be a reliable indicator of a recession.
“We are maximum inversion for the US yield curve today. 2s10s near -55bps and 2s30s close to -56. That’s a signal, after the retail sales report, that recession is coming,” tweeted Edward Harrison, senior markets editor for Bloomberg.
A yield curve inverts when long-term interest rates drop below short-term rates, indicating that investors are moving money away from short-term bonds and into long-term ones. This suggests that the market as a whole is becoming more pessimistic about the economic prospects for the near future, according to Investopedia.
“Higher bond yields are bad news for the stock market and its investors,” said certified financial planner Paul Winter, owner of Five Seasons Financial Planning.
The yield curve inversion has been a relatively reliable recession indicator. Because yield curve inversions are relatively rare but have often preceded recessions, they are typically scrutinized heavily by financial market stakeholders.
The shape of the curve is one of the most widely watched financial-market barometers because it reflects bondholders’ views of where interest rates and the economy are headed, Bloomberg reported. When the curve inverts, with long yields dropping below short ones, it signals expectations of a slowdown that will drive rates lower in the future.
Higher bond yields create more competition for funds that may otherwise go into the stock market, Winter said, and with higher Treasury yields used in the calculation to assess stocks, analysts may reduce future expected cash flows.
Also, it may be less appealing for companies to issue bonds for stock buybacks, a way for profitable companies to return cash to shareholders, Winter said.
Images: Edward Harrison, Bloomberg Senior Markets Editor (Twitter) / U.S. yield curve chart, https://www.gurufocus.com/yield_curve.php