What does the inverse yield curve mean for fixed income investors

BY   |  TUESDAY, 7 JUN 2022    3:29PM

The US interest rate yield curve recently moved into inverse territory, causing concern among some, but not all fixed-income investors. This paper looks at what the inverse yield curve means for those investors who have diversified into credit to improve their investment income.

The interest rate yield curve is determined by the market as it weights collective information to 'bet' on what central banks will do next with their policy rates.

For example, if the US Federal Reserve is forecast to raise rates to 2% in 12 months' time to counter inflation, then any fixed income investment earning less than that could be considered a poor investment. But, if the US economy remains weak and the US central bank keeps rates near zero, than a 1.5% yield would obviously remain attractive.

At present, US inflation is expected to rise rather than weaken and most central banks, in particular the US Federal Reserve, are preparing to further raise interest rates - and as a result bond yields are rising. By March 2022, the US two-year bond yield had risen from 1.6% to 2.3%

Editor's note: On 4 May 2022, the US Federal Reserve lifted its benchmark interest rate by half a percentage point to a range of 0.75% to 1%, its biggest increase in 22 years.

Once the 10-year rate is less than the two-year rate this signals a flattening of the yield curve, to the point where the gap between these two rates recently moved to an inversion where the 10-year rate of return went below the two-year rate.

This yield curve inversion is often seen by the professional market as a leading indicator of recession and it often has often been accompanied by the US Federal Reserve initially raising interest rates quite aggressively, but then at some point stops and again begins to cut rates as they believe inflation is under control and they need to prime the economy again as it is weakened somewhat from those higher interest rates; all the while creating uncertainty.