Investing

Why Wall Street is watching the bond market — and what a yield curve inversion means

Anna-Louise Jackson@aljax7
Twenty/20

The bond market is making history lately, but it's also causing jitters on Wall Street. Yields on Treasury bonds have been slumping, signaling that investors are nervous about the pace of economic growth ahead — and that's contributing to the stock market's recent wild ride.

The yield on the 30-year Treasury bond fell to a new all-time low on Wednesday. Meanwhile the so-called yield curve — which measures the difference in interest rates for two bonds with different maturity dates — has been flashing a warning sign this month. Economists are paying attention because the yield curve has historically been an accurate predictor of recessions.

Here's what you need to know about the yield curve, and why people are talking about it.

First: A refresher on how bonds work

The yield curve is a closely watched dynamic in the bond market, because it illustrates whether investors are more comfortable with making short- or long-term bets on the U.S. economy.

Bonds are historically less risky than stocks, and U.S. Treasury bonds are considered to be among the safest investments because the federal government has never defaulted on its debt. When traders want to shield their portfolios from possible bumpiness in the stock market, they often seek the safety of assets like bonds.

And when a bunch of traders are anxious to buy bonds all at once, that demand pushes prices higher. In turn, the yield — or return you'll earn — falls.

What a yield curve inversion means

The rush to buy bonds recently has pushed yields lower, especially for long-term bonds. The yield on 30-year Treasurys fell to an all-time low of 1.907% Wednesday, a rate that is lower than the yield on the 3-month note.

That's concerning to people who watch the bond market. Normally, when the economy is expanding, the interest rate on long-term bonds is higher than that of short-term bonds.

But when investors are worried about an economic slowdown or a recession in the near future, they'll require higher returns to invest in short-term bonds — what's known as a yield curve inversion. An inverted yield curve is among recession indicators that professional investors track, and is currently the one causing the most concerns.

The two yield curves that are most closely tracked are:

  • The 10-year Treasury yield versus the three-month Treasury yield
  • The 10-year Treasury yield versus the two-year Treasury yield

Both of the above yield curves have inverted this year, which shows that investors are worried about an economic slowdown ahead.

The spread between the 10-year Treasury yield and the three-month Treasury yield has "the strongest predictive power," according to research from the Federal Reserve Bank of San Francisco, which shows that such an inversion has preceded every U.S. recession in the past 60 years.

But professional traders prefer tracking the spread between the 10-year and two-year yields as an indicator of a recession — and this yield curve has now inverted multiple times in recent weeks. There have been five similar inversions since 1978 and each one preceded a recession by an average of 22 months, according to data from Credit Suisse.

Why some experts say this inversion is different

Don't take a yield-curve inversion as a sure sign. Other key recession indicators — including unemployment — have yet to signal warnings about the pace of economic growth. Just because an inverted yield curve has been a reliable indicator in the past, it "isn't just a switch" that causes a recession, Paul Hickey, cofounder of Bespoke Investment Group, told CNBC this week.

A recession is coming at some point: These downturns are a normal part of the economic cycle. But even the experts have difficulty predicting when that will happen.

While 38% of economists expect a recession by the end of 2020, another 34% don't see one happening until sometime in 2021, according to the results of an August survey by the National Association for Business Economics. Five years ago, some economists were forecasting the economy would enter a recession within two years — and of course it never did.

Still, there are steps you can take now that will help prepare both your career and finances for whenever growth slows. And when it comes to your investments, it's always important to have a mix of assets in your portfolio to help reduce your overall risk. You shouldn't rush to bonds just because other traders are doing so. Rather, stay the course with your long-term investment strategy.

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