Unexpected Risks and Opportunities from the Inverted Yield Curve

Many investors have attempted to capitalize on the inverted yield curve by purchasing long-term Treasuries (assuming continued declines at the long end will cause their bonds to appreciate). In his latest commentary, Venk Reddy, CIO of our Sustainable Credit Strategies, explains why he feels this approach is materially riskier than investing in short duration fixed income.

In theory, yield curves should be upward sloping, with longer rates higher than shorter rates. Investors usually demand higher returns when they commit their money for longer periods. This includes most financial services, where the core business is to “borrow short, lend long.” A stable financial system depends on it.1

Every so often, however, the yield curve inverts. The reason is usually fear of an impending recession. Take today’s rate environment for example. The Federal Reserve raised its benchmark interest rate target to 4.50% - 4.75% on February 1. The goal of current Fed policy is to lower inflation, a key driver of long-term interest rates. Meanwhile, many traders believe an economic recession is likely at some point in 2023, and they believe this would result in the Fed reversing course and lowering interest rates. Both outcomes would mean lower interest rates in the future. This can be seen in Figures 1 and 2, which show the current yield curve and the implied fed funds rates (based on futures prices) through 1/31/2024.2

Yield Curve Dollar Swaps Chart
Figure 1: U.S. Interest Rate Swaps curve as of 2/1/2023 (Source: Bloomberg Finance, LP)
Implied Overnight Rate Bloomberg Chart
Figure 2: Implied fed funds overnight rates and number of interest rate hikes/cuts through 2/10/2023 (Source: Bloomberg Finance, LP)