After a little over two years, the yield curve is back to normal. That is to say, interest rates on longer-term bonds are once again higher than the interest rates of shorter-term bonds like two-year Treasuries.
Rates on 10-year Treasury bonds first fell below two-year Treasury rates back in July 2022, when investors feared then-rampant inflation would lead to a recession. Part of this defensive preparation included buying long-term bonds -- even at subpar interest rates -- since other kinds of investments could soon be losing ground. As of this week, though, this dynamic is no longer in place.
Except the uninversion of the long-inverted yield curve isn't quite what it seems to be on the surface. The inversion has been undone mostly because the market's now betting on more aggressive rate cuts than previously expected, suddenly dragging long-term interest rates much lower than shorter-term rates have fallen. And regardless of how it happens, the reversal of such an inversion doesn't necessarily mean we've sidestepped trouble. The recessions often predicted by a yield curve's inversion typically don't start until after the inversion is unwound.
In other words, now's a good time to start thinking about playing a little defense.
What is the yield curve anyway, and why should I care?
This doesn't mean you should panic! It's too easy to make bad decisions when you're panicked. Besides, even if the worst-case scenario from here isn't apt to be devastating in the grand scheme of things. It's more likely to just be annoying to true long-term investors.
Still, you need to know what's likely (and why), so you can plan accordingly.
The term "yield curve" is a way of visually describing how interest rates on bonds and other bond-like instruments vary with different maturities. Longer-term bonds (20-year and even 30-year) typically offer higher yields than shorter-term bonds (like 10-year Treasuries), which boast better yields than the shortest-term paper (such as three-month T-bills). Interest rates rise and fall over time, but in a normal environment, the further away maturity is, the higher the interest rate.
This relationship breaks down, however, when investors start seeing the sort of red flags that began waving in the middle of 2022. As the graphic below shows, that's when yields on two-year Treasuries moved above interest rates on 10-year government bonds. The blue line on the bottom of the chart shows the same thing in a different way, plotting the mathematical difference between the 10-year and two-year Treasury yields. This line finally turned negative in July 2022. That's the inversion of the yield curve you've been hearing about ever since.
10 Year Treasury Rate data by YCharts
But why did this happen? Fearing market weakness was on the horizon, people started locking in low interest rates on long-term bonds even though they could have achieved better returns on short-term instruments like three-month Treasuries and even certain money market funds.
A little something now and later is better than a lot of nothing for a long time. That's why inverted yield curves are often seen as a warning of an impending recession, in fact -- investors sense that trouble awaits even if they don't consciously know it.
As the chart above also shows, the yield curve has actually been inching its way back an uninverted status since the middle of last year. The 10-year/two-year comparison finally got over that hump (albeit only briefly) on Monday of this week thanks to recent headlines. In the meantime the spread between 30-year and 10-year Treasuries has also widened to levels not seen since the volatile first half of 2023.
10-2 Year Treasury Yield Spread data by YCharts
Crisis averted? Not quite.
This is when the trouble usually starts
Yield curve inversions are a reasonably reliable warning of a recession. But given how the yield curve remained inverted for over two years without an economic recession ever actually taking shape, predictions of a so-called "soft landing" began holding water. Maybe we could escape this mess mostly unscathed.
However, the recessions that yield curve inversions predict typically don't start until the curve uninverts ... as it just did.
The image below tells the tale; U.S. recessions are highlighted in gray. Notice the economic weakness in question tends to take hold a few months after interest rates start trending in their new, current direction.
10-2 Year Treasury Yield Spread data by YCharts
It's possible this time will be different. This particular inversion was in place for a freakishly long time, and deeply so at its trough. It was also mostly rooted in the unusual circumstances behind and because of the COVID-19 pandemic.
From an odds-making perspective though, the foreseeable future looks troubling -- even if it's going to only be temporary trouble.
As for what you need to do about it now, first and foremost, don't panic! Recessions happen. We get past them sooner or later. They always end up being great buying opportunities. If you feel like you must take some sort of specific defensive action right now, however, perhaps just start by shedding any of your questionable holdings. Although economic weakness and subsequent market weakness works against all stocks, it doesn't work against them evenly. Some weaker companies will be so banged up by a recession that they simply can't dig their way out afterward.
As for your other, more resilient stocks, though, your best bet is still sticking with them and just taking your lumps, having faith that they'll snap back when the time comes.
This might help you do that: Mutual fund company Hartford's data reveals that half of the market's highest-gaining days since 1994 actually unfurled during a bear market, while more than another one-fourth of the biggest were seen during the first two months of a bull market when many investors are still on the sidelines.
In other words, stay cool here. You've got time to ease into any defensiveness you'd like to shore up before the risk of sustained headwinds gets real.
