Everything you need to know about inverted yields

When people think of yields, they think rising interest rates, dividend payments and bond coupons—most have never heard the term inverted used before the world yield. Now’s the time to understand it, because you’ll be hearing a lot more about them in the months ahead. Historically, when yield curves invert, as they did last week, a recession isn’t far behind.

What is an inverted yield?

Typically, 5, 10 and 30-year bonds have higher yields, and pay more, than short-term bonds of 2 and 3 years. That’s because there’s more risk in holding longer duration bonds than ones that will come due in a couple of years. If you look at a chart of U.S. Treasuries, you’d see yields rising higher, or lower, more or less in unison. An inverted yield curve occurs when yields on longer duration bonds fall below yields on shorter term bonds. That’s what happened on December 3, when, for the first time since 2005, U.S. 2- and 3-year bond yields were higher than the 5-year U.S. Treasury bond.

Wow, that sounds crazy… right?

At the very least, it’s something to watch. According to Jeff DeVack, a fixed income portfolio specialist with T. Rowe Price, the relationship that matters most is the one between the 2-year bond and the 10-year bond. While that line hasn’t been crossed yet—the yield on the 10-year U.S. Treasury is 2.85%, while the yield on the 2-year is at 2.72%, the gap is narrowing. If the 10-year treasury yield does fall below the 2-year, then watch out. (We’re talking U.S. bonds here. While Canadian bonds can invert, too, it’s U.S. fixed income that predicts recessions best. And, when the U.S. goes into a recession, the rest of the world tends to suffer.)

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Why is this a big deal?

Every recession, at least since 1955, has been preceded by an inverted yield curve. Until 1972, when the 2-year note was introduced by the U.S. government, it was the relationship between the 3-year and the 10-year that mattered most. Since the two-year treasury was introduced, America has experienced five recession and each one has followed a yield curve inversion. It doesn’t have invert by much, it just has to invert.

Related: Should you invest actively or passively in bonds?

Why does this happen?

It’s a combination of factors. Right now, the U.S. Federal Reserve is trying to slow down the U.S. economy by raising America’s Fed Funds rate, which it’s done eight times since 2015 and two or three more hikes are likely coming over the next 12 months. If it didn’t raise rates, and they remained low, then inflation would get out of control, which would cause prices for the goods we buy to rise too quickly. However, when the overnight rate rises, short-term bond yields climb.

While long-term bond yields can also jump as a result of a higher Fed Funds rate, other factors influence 10- and 30-year bonds yields. Bond markets tend to be forward-looking and, right now, they’re telling us that the U.S. economy will slow over the next couple of years. We know that because people are buying more long-term bonds, which then pushes yields down—the yield on the 10-year U.S. government bond has fallen by nearly 10 percent since October 3. Investors want to lock in at 2.85 percent today because they think rates could fall further if the economy slows. For instance, if the Federal Reserve has to cut rates again as a result of slower growth, or if people start rotating out of equities and into bonds, then yields could drop. That matters to investors because when yields fall, bond prices rise.

It’s those two forces—short-term yields rising because of an increasing Fed Funds rate, and long-term yields falling because of economic concerns—that cause yields to invert.

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So, is a recession coming?

If it comes, and it’s always possible that this time might be different, it won’t be for a while. The average time from inversion to recession is 16 months. What’s also interesting is that the curve tends to steepen before we actually enter a recession. Why? Because, again, the market is forward-looking, so it starts anticipating the end of the recession, even before we enter one.

So, a recession is coming, but just not yet?

Based on history, that’s right, though DeVack thinks growth will continue for at least the next 18 months. But even if a recession occurs, it doesn’t mean the markets will experience at a 2008-style crash. The definition of a recession is two consecutive quarters of negative growth, though most U.S. recessions last, on average, 11 months, he says. (The Great Recession lasted about two years—an anomaly.) Markets also don’t usually fall by 40 percent during a recession. In fact, according to Richardson GMP, stocks are flat, on average, during a recession and make money 55% of the time. The worst period for stocks is the six months before a recession where stocks fall, on average, by 3.2%.

As someone who holds bonds and stocks, what should I do?

If you believe a recession is on the horizon then it may be time to get more defensive with your equities. Buy more consumer staples and utilities stocks, or companies that tend to do well regardless of economic conditions. On the bond side, DeVack says to buy higher quality corporate bonds, which are at less risk of a default than lower quality ones, and while you could buy longer term bond, you don’t have to purchase the longest term bonds. The portfolio he represents has an average duration of six years.

The inverted yield curve may seem like one of the quirkier figures to follow, but it’s been a reliable recession-measuring metric, so far. The more you understand it now, the more you’ll be prepared for when a recession eventually arrives.