What’s a yield curve disinversion—and should you be worried?

The U.S. yield curve is a common measure of bond investors’ feelings about risk. For the past two years, it’s been inverted, which means investors think there is more risk in the short term than the long term. Last week it flipped back to normal, or “disinverted.” A yield curve disinversion is often a sign of recession—but not always. 

The yield curve measures the difference between the yield to maturity of the 2-year Treasury bond to the 10-year Treasury bond. Because the bonds are of the same quality and of the highest possible rating, the yield curve becomes a proxy on how bond investors view near term risk versus longer-term risk. 

A normal yield curve is one in which the 10-year Treasury yields more than the 2-year Treasury. This makes sense—ten years is further into the future, and therefore riskier. But in July 2022, the yield curve inverted. It stayed that way until last week, when it inverted in anticipation of rate cuts. 

Conventional wisdom says that a yield curve disinversion usually signals a recession. That’s because shorter-term bond rates tend to fall when the Federal Reserve lowers policy rates in anticipation of an economic slowdown. But in our view, that’s not what’s happening this time around, so it’s important to understand what the Fed is thinking before making your own asset allocation decisions.  

The Fed isn’t cutting rates to switch to an accommodative stance. Instead, it signaled that a change in its policy stance is warranted now that inflation is sustainably lower (the stable prices side of its mandate) and to stem further weakness in the labor market (the employment side of its mandate). 

Keep in mind that even after the Fed cuts rates, the policy rate will still be above the perceived neutral rate. So monetary policy will still be restrictive—just less restrictive. However, the Fed risks moving too slowly or misjudging incoming economic data. 

While some market watchers are concerned, we see three key reasons why this does not necessarily signal an impending recession: 

• The recent rise in unemployment is attributed more to an increase in labor supply, largely from immigration, rather than a collapse in demand for labor. Though we have seen some softening in demand (e.g. fewer job openings), we have not seen widespread layoffs—and do not foresee unemployment escalating uncontrollably.  
• While there is some stress on lower-end consumers, higher-end consumers—having generated tremendous wealth from asset appreciation and higher real incomes —should continue to spend.  
• Economic growth remains close to its trend and 2Q24 GDP was revised up to 3%. Even if there's a slowdown towards the year's end, we anticipate the economy will continue to expand. 

There are several ways for investors to play the disinversion of the yield curve. On the fixed income side, we favor investments tied to higher-income consumers. In addition, we continue to like duration and credit spread as we are not expecting a default cycle. We also expect an increase in opportunities further out on the curve, which had previously been less attractive when the curve was inverted.   

On the equity side, we expect the trend of broader participation into more defensive sectors, which began earlier this year, to persist. 

On an overall multi-asset allocation basis, we continue to overweight U.S. equities with a bias towards higher-quality areas of the market, while remaining cognizant of any risks or opportunities that may arise.  

Maverick Lin contributed to this article.