2-year, 10-year, inverted yield curve…what does it mean?

The 2-year rate and the 10-year rate are both measures of the yield on government bonds, which are debt securities issued by governments to borrow money from investors. The 2-year rate represents the yield on a two-year bond, while the 10-year rate represents the yield on a ten-year bond. These rates are also affected by inflation expectations, as investors will demand higher yields to compensate for inflation risk. The 10-year rate is also often used as a proxy for mortgage rates.

Interest rates are the cost of borrowing money, and they are determined by the supply and demand for credit in the economy. When inflation is high, interest rates tend to rise as lenders demand higher compensation for the increased risk of lending money in an inflationary environment. Similarly, when inflation is low, interest rates tend to fall as lenders compete for borrowers and demand for credit is lower.

Overall, the 2-year rate, the 10-year rate, and interest rates are all interconnected, reflecting the interplay between inflation expectations, supply and demand for credit, and the cost of borrowing money.

In general, when inflation is expected to rise, longer-term interest rates (such as the 10-year rate) will rise more than shorter-term rates (such as the 2-year rate), reflecting the higher inflation risk associated with longer-term investments. Conversely, when inflation expectations are low, shorter-term rates may be higher than longer-term rates, reflecting lower inflation risk.

When the 2-year rates are higher than the 10-year rates, it is referred to as an inverted yield curve. An inverted yield curve is a situation where the yields on shorter-term bonds are higher than the yields on longer-term bonds.

This situation is relatively rare but can be an indicator of an impending recession. We are experiencing an inverted yield curve right now, mostly brought on by central banks, raising interest rates too fast. In normal circumstances, longer-term bonds should have a higher yield than shorter-term bonds, reflecting the increased risk of holding bonds over a longer period. However, when short-term rates are higher than long-term rates, it suggests that investors expect weaker economic growth and lower inflation in the future, leading to lower long-term rates.

The inversion of the yield curve can create challenges for banks and other financial institutions that rely on borrowing at short-term rates and lending at long-term rates, as their profit margins can be squeezed. The recent bank issues in the US were a reflection of that. It can also affect investor behavior, leading to a shift away from stocks and more towards bonds.

While an inverted yield curve is not a guarantee of an impending recession, it has been a reliable indicator of past recessions. As such, investors and policymakers closely monitor the yield curve to help inform their decisions. That’s one of the reasons that I have started increasing the bond components in some portfolios. However, some indicators for a recession have been declining lately and portfolios are on a re-bound, especially the ones that experienced a steeper decline last year.