How Inverted Yield Curves Impact Consumers, Equities, and Bonds

How Consumers Can Be Affected by Inverted Yield Curves

Consumers seeking short-term loans tend to be worse off amidst an inverted yield curve. Interest rates rise and costs of borrowing go up, leading consumers to either pay higher prices or defer purchases and investments altogether.

This unfriendly environment tends to sour the consumer’s mood. Though inverted yield curve explained as a phenomenon that tends to precede recessions, decisions made by consumers can ultimately flip the switch and force the economy into contraction.

For each of the six recessionary periods (noted by the gray bars in the graph below), and also at the time of an inverted 10-2 year or 10 year-3 month spread, the University of Michigan’s US Consumer Sentiment Index was either declining, below its historical average, or both. The same goes for the US Consumer Price Index, which was either on the rise, above its historical average, or both in all six periods.

The Consumer Sentiment Index hit an all-time low of 50 last June right as the 10-2 year spread turned negative and inflation peaked at 9%. The index is currently around the same level as it was at the end of the Great Recession of 2007-2009.

Interestingly, the 10 year-3 month spread moved in the opposite direction of consumer sentiment last year. As the Consumer Sentiment Index plummeted to historical lows, the 10 year-3 month spread widened. It seems the 10 year-3 month spread caught up to the reality of depressed consumer sentiment and the highest CPI in four decades.

 

How Equities Can Be Affected by Inverted Yield Curves

Companies in the business of short-term borrowing and long-term lending, such as banks, have historically underperformed when the yield curve inverts. Borrowing costs increase near-term, and profits get compressed when long-term loans are issued with less attractive rates.

Stocks bearing high dividend yields are also thought to be less attractive when short-term rates spike. Yield-seeking investors may flee equities in favor of shorter-term treasuries since payments can be captured without inheriting company risk.

On the flip side, companies that issue short-term loans would expect to see a bump in interest payments. The same goes for companies with large amounts of liquid assets. Two of the largest companies on earth, Apple (AAPL) and Berkshire Hathaway (BRK.B), have historically logged large figures on the Cash and Short-Term Investments lines of their respective balance sheets. When short-term rates rise, these companies can expect a greater return on any new short-term investments.

 

How Fixed Income Can Be Affected by Inverted Yield Curves

Inverted yield curves raise short-term US treasury yields closer to those of riskier bond types such as junk bonds, corporate bonds, and also real estate investment trusts (REITs). When the spreads between lower-risk US treasuries and these higher risk, non-Treasury backed securities contract, the US treasuries are seen as more attractive.

This chart of Moody’s Aaa Corporate Bond vs. the 2-Year Treasury and High Yield Junk Bond vs. the 2-Year Treasury shows the narrowing spreads between these usually riskier instruments and short-term treasuries during an inverted yield curve.

When a flat or inverted yield curve lifts short-term treasury rates closer to or greater than long-term ones, this presents a situation in which investors could lock in a similar interest rate at a lower duration to maturity. One thing to note: if short-term rates continue rising, then that bond value would likely decrease. But, assuming the investor is willing to accept implied short-term risk and believes the issuer (the US government) won’t default, he or she might have an opportunity to achieve a greater effective yield from their cash.

 

The Bottom Line

The yield curve has been inverted since July 2022, but history has shown that any economic fallout following an inverted yield curve doesn’t happen immediately. Investors that take cues from the 10-2 year spread might look to the 10 year-3 month spread as well, as both have preceded all six recessions that have occurred dating back to 1980.

Like any other market event, an inverted yield curve causes its own share of winners and losers. Commercial airlines pilots such as American, Southwest, and United, who are prepared with a strategy fit to weather near-term events will eventually see the light at the end of the tunnel when the yield curve gets back to normal.

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