Key takeaways
The Treasury yield curve is flattening after being inverted for most of the last two years.
Inversion, an unusual scenario, means yields on shorter-term Treasury securities are higher than those of longer-term securities.
While an inverted yield curve is viewed by some market observers as a harbinger of recession, since 2022 – when the yield curve for Treasuries inverted – the economy continued expanding.
The yield curve for Treasury securities is normalizing after inverting for the better part of the last two years. An inversion between the 2-year and 10-year Treasury has already returned to a somewhat normal slope, as 2-year yields fell below those of 10-year Treasuries. Three-month Treasury bill yields remain high, meaning an inversion is still evident, but less pronounced than before. Between 3-month and 30-year maturities on the yield spectrum, differences are marginal, and the curve has flattened.1
A yield curve plots the interest rates paid by bonds of comparable credit quality across various maturities. A Treasury yield curve provides a comparison of government-issued bond yields of different maturities. A typical yield curve will trace current yields for Treasury debt securities with yields of three months, two years, five years, ten years and 30 years.
Earlier in 2024, in anticipation of the Federal Reserve’s (Fed’s) plans to begin lowering the federal funds target rate (a rate used by banks for overnight lending that influences mortgage rates, credit cards and automobile loans), bond market yields almost uniformly declined. Yields across the board are generally lower than peak levels reached earlier in 2024.1 The fed funds target rate of 5.50% on the upper end was historically high and had held steady since mid-2023. The Fed implemented a 0.50% rate cut in September and trimmed it an additional 0.25% in November. Nevertheless, since mid-September, longer-term bond yields trended higher. The 10-year U.S. Treasury yield moved from 3.63% on September 16 to 4.44% two months later.1
“What’s happening with market rates despite Fed rate cuts is somewhat to be expected,” says Rob Haworth, senior investment strategy director for U.S. Bank Asset Management. “The Fed is reducing short-term rates, which has more direct impact on short-term yields,” such as 3-month Treasury bills. Haworth notes that at the same time, the Fed is reducing its own holdings of longer-term U.S. Treasuries and mortgage-backed securities.
Up until 2022, the Fed purchased Treasury and mortgage-backed securities to help maintain modest interest rates and by doing so, boost economic activity. In 2022, the Fed changed its approach as part of a strategy to slow economic activity with hopes of reducing rampant inflation. It raised interest rates and reduced its balance sheet of bond holdings. “The Fed today is maintaining an approach that, in effect, requires other investors to step in and purchase Treasury bonds,” says Haworth.” “If investors are reluctant to do so, that requires the Treasury to offer higher yields to attract those dollars.” Yet Haworth believes the Fed is not likely to be concerned with recent longer-term bond yield increases if 10-year Treasury yields remain below 5%.
The yield curve compares current interest rates, or yields, on debt securities across various maturities. Investors typically demand higher yields when investing their money for longer periods of time. This is referred to as a normal, upward sloping yield curve, as depicted below, reflecting the actual Treasury yield curve at the end of 2021.1
At rare times, the yield curve inverts, which means that yields on some shorter-term securities are higher than those for some longer-term securities. This occurred in 2022, but the curve is less inverted today than was the case previously. Today’s curve is flatter than the much more inverted curve of early 2023.
Earlier in 2024, yields on 2-year Treasuries fell below those of 10-year Treasuries, ending the inversion between those two maturities. Three-month yields remain higher than most other Treasury offerings, but the gap between 3-month and 10-year Treasuries, another closely watched inversion measure, has narrowed considerably since September 2024.
For some market observers, the onset of an inverted yield curve is considered a harbinger of economic recession. However, the current yield curve inversion proved, to this point, to be a false recession signal. To the contrary, the U.S. economy showed tremendous resilience. As measured by Gross Domestic Product (GDP), the economy grew by approximately 3% (annualized rate) in 2024’s second and third quarters.2 “The environment was not conducive to a recession because of COVID-era fiscal stimulus that built individuals’ savings, and because this economy was not driven by a lack of demand,” says Haworth. In fact, consumers were ready to spend as the COVID economy receded, employers added jobs and boosted worker pay.
“Companies had the ability to charge more for goods and services because people were in a strong enough financial position to pay for them,” says Haworth. “That put the economy in a strong position. As a result, even as rising interest rates created headwinds, the economic expansion continued.
For investors holding a diversified portfolio of equities, fixed income and real assets, Haworth says it may be time to consider modestly underweighting fixed income investments. “Given the opportunities in other parts of the market, such as global equities, investment grade bonds are likely to generate lower relative returns in the near term.”
Haworth also notes there’s increasingly positive investor sentiment for non-Treasury segments of the market. With certain non-taxable portfolios, this includes non-government agency issued residential mortgage-backed securities, while managing total portfolio duration using longer-maturity U.S. Treasuries. Certain tax-aware portfolios can benefit from municipal bonds, including some longer-duration and high-yield municipal securities. Trust portfolios may benefit from reinsurance as a way of capturing differentiated cash flow with low correlation to other portfolio factors such as economic trends.
Check-in with your wealth planning professional to make sure you’re comfortable with your current mix of investments and that your portfolio’s asset allocations remain consistent with your goals, risk appetite and time horizon.
A yield curve plots the interest rates paid by bonds of comparable credit quality across various maturities. A Treasury yield curve provides a comparison of government-issued bond yields of different maturities. A typical yield curve will trace current yields for Treasury debt securities with yields of three months, two years, five years, ten years and 30 years.
Typically, investors expect to earn higher yields from bonds with longer maturities. In a normal environment, the yield curve will be upward sloping. For instance, that means the yield on shorter-term bonds will be lower than the yield on longer-term bonds. However, in certain circumstances, the yield curve inverts and slopes downward. In this environment, yields on short-term securities exceed those of long-term securities. While some market observers view an inverted yield curves as harbinger of recession, that hasn’t happened in the current cycle since the yield curve first inverted back in 2022.
The yield on a U.S. Treasury security, its effective interest rate, indicates the income that will be generated for an investor when purchasing a bond. For instance, when investing $10,000 in a 10-year U.S. Treasury note with a 4% yield, the investor will be paid income of $400 per year. Bond yields are locked in when an investor purchases a specific security, but yields paid by newly-issued U.S. Treasury securities will vary on a day-to-day basis.
The Federal Reserve has started easing monetary policy by cutting interest rates. Does this mean the threat of a recession has receded?
A fresh look at managing your cash and investments in today’s changing interest rate environment can help support your pursuit of the goals that matter most to you.
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