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Key takeaways
While interest rates seem poised for adjustments in 2024 – based on the likelihood of evolving Federal Reserve monetary policy – an unusual environment that emerged in 2022 persists today.
Yields on some shorter-term Treasury securities continue to exceed those of most longer-term Treasuries.
While this so-called “inverted yield curve” is viewed by some market observers as an indicator of potential recession, the economy today continues to prove resilient.
The bond market experienced modest changes in 2024’s opening months. Rates on medium- and long-term Treasury debt securities trended higher while yields on shorter-term Treasuries remained relatively steady. This served to “flatten” the yield curve, but not yet correct a persistent yield curve inversion that first emerged in late 2022. The inverted curve is driven primarily by recent Federal Reserve (Fed) interest rate hikes. Short-term yields across the bond market track closely with the Fed’s higher federal funds rate, with longer-term yields rising as well, but generally not to the same degree.
The Fed's interest rate actions were in response to inflation ramping up in 2021 and 2022. The Fed boosted the federal funds rate, which was near 0% in early 2022, to a range of 5.25% to 5.50% by July 2023. As a result, publicly traded bond yields moved higher across the board, with the most dramatic increases occurring among shorter-term instruments. As the Fed intended, inflation declined significantly, though it remains above 3%, while the Fed wants inflation closer to 2%. The Fed has outlined plans for potential 2024 cuts to interest rates,1 but with inflation holding steady in recent months, the Fed appears in no hurry to get started.
Understanding the yield curve
A simple way to view the yield curve is by comparing current interest rates, or yields, on U.S. Treasury securities with maturities of three months, two years, five years, 10 years and 30 years. Investors typically demand higher yields when investing their money for longer periods of time. This is referred to as a normal, upward sloping yield curve. In this scenario, yields rise along the curve as bond maturities lengthen. The chart below depicts a normal, upward sloping yield curve among these U.S. Treasury securities of varying maturities, depicting actual yields in the Treasury market at the end of 2021. At that time, the yield on 3-month Treasury bills stood at 0.05% and moved progressively higher as maturities extended along the yield curve, up to a yield of 1.90% on 30-year Treasury bonds.2
However, at rare times, the yield curve “inverts.” The use of this term does not necessarily indicate that the slope moves consistently higher to lower across the yield spectrum when reading the chart from left to right. But it can mean that yields on some shorter-term securities are higher than those for some longer-term securities.
In late October 2022, the yield on the very short-term 3-month Treasury bill moved above that of the 10-year Treasury note, and that inversion continues today.
The inversion today is flatter than it was during periods in 2023. As of April 25, 2024, the yield on the 3-month Treasury bill was 5.47%. By comparison, the yield was 4.70% for the 10-year U.S. Treasury note, a 0.77% spread. The spread, or yield advantage for 3-month Treasuries over 10-year Treasuries, was as high as 1.88% in May 2023.2
Fed’s role in yield curve dynamics
The yield curve’s direction is likely to be highly dependent on Fed interest rate policy, says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Short-term bond yields are firmly anchored to the Fed’s rate moves.” Haworth notes that while 3-month Treasury bill rates held relatively firm in recent months, yields on 2-year U.S. Treasury notes and some longer-term bonds reflected investor perceptions about pending Fed rate cuts. For example, 2-year Treasury bill yields exceeded 5% in mid-October 2023. As speculation grew that Fed rate cuts could occur in early 2024, the yield dropped more than 1%, to 4.14%, by mid-January. However, as it became apparent the Fed was in no rush to begin fed funds rate cuts, the 2-year yield jumped back up near 5% in late April.2
While Fed officials have indicated that rate cuts will likely occur in 2024, the timing of those cuts is in question. Economic data released so far in 2024 has created more skepticism that rate cuts will happen in the near term. “The inverted yield curve is most likely with us until those Fed rate cuts begin,” says Haworth.
He also points out that (as indicated in the April 25, 2024, yield curve chart above), the yield curve between five-year and 30-year bonds has begun to return to a more normal slope. “The inversion at this point is just with the very low end of the yield curve in comparison to longer-term bonds,” says Haworth. After its March 2024 meeting, Fed chair Jerome Powell confirmed expectations that interest rate cuts were still likely in 2024, a sign that the Fed is close to achieving its goals of taming inflation. However, he also made clear that “we are prepared to maintain the current target range for the federal funds rate for longer, if appropriate.”3
The yield curve’s direction is likely to be highly dependent on Fed interest rate policy, says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Short-term bond yields are firmly anchored to the Fed’s rate moves.”
When will the yield curve return to normal?
With the yield curve flattening in recent months, the next question is when to expect a return to a normal, upward sloping yield curve, when long-term bond yields exceed those of shorter-term bonds. Haworth sees two different scenarios, one preferred over the other.
“If long-term bond yields begin to fall, it’s likely because inflation is declining. Once that occurs, the Fed will feel more comfortable cutting short-term rates.” Haworth believes that the preferred way to see the yield curve return to normal is with short-term rates declining more precipitously than long-term rates. Declining short-term Treasury yields would likely follow fed funds rate cuts.
Haworth says the “Goldilocks” version of this scenario is one where declining inflation is paired with a growing economy. “In this circ*mstance, the Fed will feel more confident about its ability to lower rates without risking a significant inflation uptick,” says Haworth.
A less desirable scenario, according to Haworth, is one where the economy appears at risk. “The Fed will cut short-term rates to offset a recession threat,” says Haworth. “That could happen, for example, if unemployment suddenly moves sharply higher, which could temper consumer spending power and trigger a recession.”
Haworth cautions about the economic challenges stemming from the current interest rate environment, as it creates headwinds for business investment. “It represents a steeper cost for corporations. With short-term rates so high, companies could become increasingly reluctant to borrow, as it is more challenging to realize a payoff when investing the borrowed capital in new equipment and facilities or added employees.” Despite this, Haworth recognizes that “many corporations are not yet showing signs of distress when it comes to their debt load and continue to maintain strong balance sheets.”.
Investment considerations in today’s unusual environment
With yields higher on short-term securities, it’s no surprise investors have put significant sums to work on the short-end of the yield continuum. However, Haworth recommends investors also consider longer-term bonds, with yields that are far more attractive today than they were at the start of 2022. “It’s important to get today’s higher, long-term rates locked in before yields begin turning lower,” says Haworth.
One consideration for bond investors is the risk of rising interest rates. When interest rates rise, values of bonds held in an existing portfolio lose market value. “A 30-year bond is much more sensitive to interest rate movements than a 6-month bond,” says Eric Freedman, chief investment officer at U.S. Bank Wealth Management. Yet Freedman believes attractive interest rates create opportunities for investors. “It may be a time for fixed income investors to spread out exposures across the maturity spectrum.”
Haworth notes there’s increasingly positive investor sentiment for non-Treasury segments of the market. With certain non-taxable portfolios, this includes non-government agency issued residential mortgage-backed securities, while managing total portfolio duration using longer-maturity U.S. Treasuries. Certain tax-aware portfolios can benefit from municipal bonds, including some longer-duration and high-yield municipal securities. Trust portfolios may benefit from reinsurance as a way of capturing differentiated cash flow with low correlation to other portfolio factors.
Check-in with your wealth planning professional to make sure you’re comfortable with your current mix of investments and that your portfolio’s asset allocations remain consistent with your goals, risk appetite and time horizon.
Frequently asked questions
A yield curve plots the interest rates paid by bonds of comparable credit quality across various maturities. A Treasury yield curve provides a comparison of government-issued bond yields of different maturities. A typical yield curve will trace current yields for Treasury debt securities with yields of three months, two years, five years, ten years and 30 years.
Typically, investors expect to earn higher yields from bonds with longer maturities. In a normal environment, the yield curve will be upward sloping. For instance, that means the yield on shorter-term bonds will be lower than the yield on longer-term bonds. However, in certain circ*mstances, the yield curve inverts and slopes downward. In this environment, yields on short-term securities exceed those of long-term securities. While some market observers view an inverted yield curves as harbinger of recession, that hasn’t happened in the current cycle since the yield curve first inverted back in 2022.
The yield on a U.S. Treasury security, its effective interest rate, indicates the income that will be generated for an investor when purchasing a bond. For instance, when investing $10,000 in a 10-year U.S. Treasury note with a 4% yield, the investor will be paid income of $400 per year. Bond yields are locked in when an investor purchases a specific security, but yields paid by newly-issued U.S. Treasury securities will vary on a day-to-day basis.
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