Liz Looks at: Why Inversion Matters

Tail over Tea Kettle

The fear-based moves in markets over the last few weeks have brought a phrase back into our conversations — curve inversion. Let’s explore what that is, what it signals about investor sentiment, and why it’s used as a forward-looking indicator.

The Long and Short of It

First things first, what the heck is a yield curve inversion? The U.S. Treasury yield curve is considered “inverted” when the 2-year Treasury yield rises above the 10-year Treasury yield, causing the curve to be downward sloping between those two points.

The way we watch this in daily market moves is to look at the spread between the 2-year and 10-year yield, otherwise known as the “2s/10s spread”. When this spread is larger (wider), the curve is further from inverting. As the spread narrows or turns negative, we are approaching, or in, inversion territory.

The reason we’re talking about this right now is because the 2s/10s spread has narrowed by more than 60 basis points since the beginning of the year, bringing it down to a small 27 basis point difference as of Mar 9.


Will the Fed Yield to Yields?

When the curve inverts, it signals a couple things. First, if investors are buying the 10-year Treasury (long end of the curve) and driving yields down, that usually means there’s a heightened level of fear in the market. That comes as a surprise to absolutely no one in the midst of a war between Russia and Ukraine, spiking oil prices alongside already high inflation, and an S&P 500 that’s down 11% YTD.

Second, if investors are selling the 2-year Treasury (short end of the curve) and driving yields up, that usually means they expect short-term rates to rise as a result of Fed rate hikes. Another surprise to absolutely no one.

But what does that mean overall? It means we’re in a pickle and so is the Fed — an inverted curve doesn’t make for good economic expectations in the near-to-medium term. I maintain the view that the Fed isn’t bothered by the correction that’s happened in equity markets, but they would be bothered by a yield curve inversion.

Why? Because yield curve inversions, much like spikes in oil prices, typically precede a recession.


So You’re Telling Me There’s a Chance…

Of a recession? Yes. There’s always a chance of a recession caused by some exogenous shock that we don’t see coming. The odds of that rise when we see other stresses in the markets or economy, or when the traditional signals start to make noise.

To be clear, the yield curve has not inverted. And for it to count as a true inversion that can be seen as a signal, the inversion would need to be reasonably persistent (one month or more, in my opinion). A brief intraday inversion doesn’t count. Even one that lasts a few days and is shallow, doesn’t count.

But given where the spread is at present, it’s important to watch this. I know the Fed is watching.


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Liz Young Thomas ABOUT Liz Young Thomas Liz Young Thomas is SoFi's Head of Investment Strategy, responsible for building out the function and providing economic and market insights. Prior to joining SoFi, Liz was the Director of Market Strategy at BNY Mellon Investment Management where she formulated and delivered views on macroeconomic themes and their effects on capital markets. Earlier in her career, she was a due diligence analyst at Robert W. Baird and a research analyst at BMO Global Asset Management. Liz is passionate about educating others on markets and investing in order to help people feel empowered to take a more active role in their financial futures.

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