The Yield Curve Rebounds

What does this mean for the markets..

After being inverted for more than 2 years (June 2022 - September 2024), last week 10YR-2YR yield curve crossed back into positive territory.

Yield curve is a very important macroeconomic indicator. It reflects market expectations for interest rates, inflation, and economic growth. Historically yield curve inversions have been followed by a recession.

Yield curve is a spread between long-term and short-term interest rates.

Long-Term rates are more driven by market expectations of inflation and economic growth while The central bank(The Federal Reserve or FED) uses short-term interest rates to control short-term economic conditions like inflation and liquidity.

In a healthy economy, investors expect future economic growth and inflation and in turn demand higher returns for locking their investments for a longer time. Thus when economic expectations are positive, longer term rates are higher than the shorter term interest rates which makes the yield curve upward sloping in a positive territory.

Post COVID quantitative easing in 2020 (asset purchase and lowering of interest rates) pumped liquidity in the system giving rise to inflation. The FED responded to this overheated economy by raising short-term interest rates. Higher short-term rates hamper economic activity by increasing borrowing costs for consumers and businesses resulting in an economic slow down and a subsequent recession. As a result, the yield curve inverted in June 2022.

Recent job reports and CPI data are both pointing towards an economic slow down. The central bank is expected to start reducing the short term interest rates in an effort to boost economic activity.

What does this mean for the markets?

S&P 500 usually responds to slower economic conditions by entering into bear market territory. It is difficult to time the recession due to significant Lead-Lag, due to dominant forces between the economy and the financial markets.

Where is the trade?

The market's rising expectations of rate cuts and lowering interest rates are bullish for US Treasury bonds. $IEF, $SHY, $TLT, $IEI, $GOVT

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