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Whence the Yield Curve Inversion?

For the third time this year, the investment interwebs are exploding with news of a “yield curve inversion,” wherein shorter-term U.S. Treasury yields are higher than longer-term yields. On the prior two occasions, the ten-year yield was below the two-year yield. On this occasion, the ten-year is below the two-year and even the one-year yield.

Sources: Round Table Investment Strategies (calculations); U.S. Department of the Treasury, (data)

The Financial Journalist Code of Clichés[1] demands that any financial article about yield inversions reference their supposed role as The Ultimate Harbinger of Impending Recession. As an advisor, I figure I’m not bound by the code of clichés, so I have nothing to say on that matter in this article.[2]

What does interest me is this: The yield curve inversion does not exist in the TIPS curve.

Sources: Round Table Investment Strategies (calculations); U.S. Department of the Treasury,
and Wall Street Journal, (data)

A nice thing about having previously published articles is that we can reference longer old articles as a means of keeping new articles shorter. For example: See subheading 2 of the Background section[3] of this earlier article for an explanation of (nominal) Treasury yields vs. (real) TIPS yields, and the notion of “breakeven inflation rates” as the difference between them. (Also for an explanation of why the word “kludgy” appears in the prior chart and the next one.)

Sources: Round Table Investment Strategies (calculations); U.S. Department of the Treasury,
and Wall Street Journal, (data)

Per footnote 15[4] of the aforementioned article, it isn’t precisely correct to say breakeven rates are market-implied future inflation rates, because the breakeven almost certainly includes a margin of error in the form of an expected return premium for investors who take inflation risk by holding nominal Treasurys.[5] But if we make the entirely reasonable assumption that the inflation risk premium is relatively stable over time,[6] then we can conclude that market-implied inflation expectations are much higher in the near-term than they are in the long-term.

Or in jargonese: The yield curve inversion is driven entirely by the term structure of inflation expectations!

In other words, while the market is currently demanding a higher nominal interest rate in the short-term than in the long-term, that is only because the market expects higher inflation in the short-term than in the long-term. If you agree to take inflation off the market’s hands, it will still accept a lower (real) rate in the short-term than in the long-term. And, again as noted before, the market expects inflation rates to drop off amazingly quickly.

“Okay, fine, cool,” you say, “but, like, what are the implications of this observation for an inversion’s status as The Ultimate Harbinger?”


Well, I have a few thoughts…but I already promised not to talk about that and I promised this would be a short article. If you want my thoughts about yield curve inversions (or else—or in addition to—our thoughts about how Round Table can potentially help with your financial plan even against a backdrop of The Ultimate Harbinger), feel free to reach out to us!

[1] Section 4, subheading 3A, paragraph 2, under “Apocalyptic Platitudes”

[2] For now, I’ll let Dimensional Fund Advisors weigh in instead:

[3] Okay, now I’m feeling a bit guilty about the joke in footnote 1.

[4] Footnote fifteen?! Sheesh, I really do feel guilty.

[5] See also footnote 14 regarding the pluralization of “Treasury.”

[6] Or even just the yet-more-reasonable assumption that the term structure of inflation risk premia is not hugely inverted.

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