📉 Yield Curve Inversion - What Is It and Why Does It Matter?

The yield curve is inverted

Traditionally, economists and market professionals look at the difference between 10-year and 2-year Treasury yields. When the difference is positive, we say the yield curve is "steep" (it slopes upward to the right, as it did a year ago). We say the yield curve is "flat when the difference is slight." When the difference is negative, i.e., 2-year yields are above 10-year yields, the curve is inverted (it slopes downward to the right), as it is today.

The Fed has reiterated its plan to fight inflation with higher rates

Today's unusual curve represents that the Fed will need to keep short-term rates high to combat inflation, even as long-term growth expectations fall. As the chart above shows, the market expects the Fed to increase policy rates to about 3.75% by early next year, up from a target range of 2.25% to 2.50% today, before allowing rates to moderate.

The housing market has softened

As it has all year long, high and accelerating interest rates affect investors and consumers in many ways. Mortgage rates, for instance, are at their highest level since the global financial crisis, with the 30-year fixed averaging 5.5%. These higher borrowing costs have cooled the housing market. The number of housing starts, new building permits, and existing homes sold have declined. The number of months of new home inventory, the ratio of new homes for sale vs. sold, has risen to 10.9, the highest since the Great Recession. 

In this environment, inflation will take time to cool down, which means that the fed funds rate will likely remain high through the first part of 2023. After the rapid historic recovery over the previous two years, a slowing economy is natural and expected. The fact that the Fed needs to thread the needle between these two challenges increases the odds of market over- and under-reactions. The recent market rally is evidence of this where many market participants were calling for a resumption of the previous bull market off of the June stock market lows, only to get hit hard when the reality of a hawkish Fed came into full view last week. The bottom line: The market recovery has hit a snag as investors adjust to new Fed expectations of tighter monetary policy for longer. With the yield curve still inverted, investors should anticipate, yet remain patient and disciplined, through an environment of continued market volatility. Avoiding the urge to overreact, especially during periods of volatility, is the key to staying on track to achieve long-term financial goals.

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