When the Yield Curve Un-inverts: One Indicator for Bond Price Movements

The US economy appears to be on track for the best-case scenario of no landing with moderate economic growth. Fed officials have also publicly signaled the possibility of delaying interest rate cuts.

What would be a good time to start investing in bonds? Here we introduce one chart that reveals the relationship between yield curve shifts and bond prices.

Negative Yield Spread and Its Reversal

Most of the time, the spread between long-term and short-term Treasury yields is positive (10-Year yield > 2-Year yield). However, when the Fed raises policy rates in response to overheated economic activity and elevated inflation expectations, short-term yields typically rise as well.

This can cause short-term yields to exceed long-term yields, flipping the yield spread into negative territory (10-Year yield < 2-Year yield), also known as yield curve inversion. This was the case in 1989, 2000, 2006, and 2022.

Prolonged yield curve inversion often prompts financial institutions to favor short-term lending due to its higher interest rate returns over long-term corporate lending, which can increase risks in financial markets. Consequently, the Fed usually aims to keep the yield spread positive.

When the spread turns negative, the central bank employs accommodative policy measures to lower short-term yields, gradually reverting the yield spread back into positive territory. During this process, the bond market often enters a bull market, as declining short-term yields push up bond prices.

As shown in the chart above, when the yield spread goes from negative to positive (marked in blue circles), bond prices will start to trend upward (marked with black arrows), until the yield spread reaches a high point.

This is because an un-inverting yield spread signifies the Fed is about to ease policy to enhance market liquidity, which will lead to a gradual increase in bond prices as short-term interest rates come down.

Conversely, when the yield spread reaches a peak and starts to decline, it means interest rate dynamics are changing again and the bond market should expect heightened volatility.

MM Takeaways

Looking at the present, yield curve inversion has persisted for 22 months since July 2022. If the Fed starts easing QT and cutting interest rates as expected in the second half of the year, the yield curve will start to un-invert, creating good entry points for bonds. Investors can continue to monitor this chart to identify the optimal timing.

?? What's your take? When will the UST yield curve inversion end? Is a bond bull market on the horizon? Comment below to share your thoughts!