What A Yield Curve Inversion Means For Traders

U.S. investors received a red flag Monday when the yield on five-year Treasury notes dipped below the yield on three-year and two-year Treasury notes for the first time since 2007. This yield curve inversion is often a sign of an imminent economic recession, so here’s a look at what the latest bond market developments mean for investors.

What Is An Inverted Yield Curve?

The yield curve is a plot of the yields of bonds with equal credit quality but different maturity dates. For U.S. investors, the most commonly referenced yield curve is a plot of 2-year and 10-year Treasury yields, which have yet to invert at this point.

A typical yield curve includes much higher interest rates for maturities further into the future. In a flat yield curve, there's little difference between short-term yields and long-term yields. Sometimes, yield curves can become inverted, a scenario in which short-term yields are higher than long-term yields. Inverted yield curves have historically occurred during periods of economic recession.

Historical Trends

The bad news for investors is that inverted yield curves have preceded each of the past nine U.S. recessions. The good news is they're far leading indicators, meaning a recession is likely not imminent.

According to the San Francisco Fed, each of the nine U.S. recessions that have occurred since 1955 came between six months and 24 months after a an inversion in the yield curve of two-year and 10-year Treasury yields.

Looking Ahead

On Monday, the difference between the two-year and 10-year Treasury yields dropped to just 0.15 percent, its lowest level since prior to the last U.S. recession. If the trend in the graph below continues, there could be a two-year/10-year yield curve inversion by the end of 2018.

If that inversion happens, investors should prepare for a potential U.S. recession as soon as mid-2019. Morgan Stanley recently forecast about a 50-percent chance of a mild “earnings recession” in 2019, which is defined as two consecutive quarters of year-over-year declines in S&P 500 earnings.

The SPDR S&P 500 ETF Trust SPY dropped marginally Tuesday morning, while the iShares Barclays 20+ Yr Treas.Bond TLT was up about 1.2 percent.

Related Links:

'We Expect Another Rangebound Year': Morgan Stanley's 2019 Investing Outlook

How Important Is The Yield Curve?

Posted In: 10-year Treasury notefive-year Treasury noteRecessionTreasury notesyield curveBondsEducationShort IdeasTop StoriesEconomicsMarketsTrading IdeasGeneral

Ad Disclosure: The rate information is obtained by Bankrate from the listed institutions. Bankrate cannot guaranty the accuracy or availability of any rates shown above. Institutions may have different rates on their own websites than those posted on Bankrate.com. The listings that appear on this page are from companies from which this website receives compensation, which may impact how, where, and in what order products appear. This table does not include all companies or all available products.

All rates are subject to change without notice and may vary depending on location. These quotes are from banks, thrifts, and credit unions, some of whom have paid for a link to their own Web site where you can find additional information. Those with a paid link are our Advertisers. Those without a paid link are listings we obtain to improve the consumer shopping experience and are not Advertisers. To receive the Bankrate.com rate from an Advertiser, please identify yourself as a Bankrate customer. Bank and thrift deposits are insured by the Federal Deposit Insurance Corp. Credit union deposits are insured by the National Credit Union Administration.

Consumer Satisfaction: Bankrate attempts to verify the accuracy and availability of its Advertisers' terms through its quality assurance process and requires Advertisers to agree to our Terms and Conditions and to adhere to our Quality Control Program. If you believe that you have received an inaccurate quote or are otherwise not satisfied with the services provided to you by the institution you choose, please click here.

Rate collection and criteria: Click here for more information on rate collection and criteria.