The Longest Inverted Yield Curve in U.S. History Continues

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Last week, without much fanfare, the United States Treasury market made history for the longest continuous inversion of the US 2s10s ever. The yield curve has now been continuously inverted since July 5, 2022 – passing the 624-day inversion from August 1978, which had held the record.

As we learn in Finance 101, an inverted yield curve is the best predictor of a recession. In fact, as a recent note from Deutsche Bank observed, the yield curve has always inverted before each of the last 10 U.S. recessions, typically with a lag of 12-18 months.

Somehow, according to the official arbiter of such things, the National Bureau of Economic Research (NBER), a recession is yet to materialize in the U.S. There are several possible explanations, not the least of which involve (1) the unprecedented levels of meddling in the natural movements of the economy by our policymakers and regulators and (2) the gargantuan levels of debt and deficit we continue to shovel at the broader economy.

For our credit union clients, however, the inverted yield curve has already taken a significant toll. First, the higher interest rates have slowed the mortgage and mortgage refinancing market that had been at the heart of much of the credit union growth over the last decade. The inverted curve has also fueled pronounced declines in bank credit and money supply. Certainly, the shape of the curve was a catalyst for the troubles that led to some of the largest bank failures on record, with Silicon Valley Bank, Signature Bank and First Republic collapsing. A significant part of those failures was a carry trade that was tempted by weak loan demand and went wrong when the curve inverted.

While the broader economy has not completely succumbed to the inverted yield curve as yet, there is no doubt that financial institutions will continue to be under stress until the longer-term visibility for the economy improves. A business that borrows money short and lends money long relies on the natural shape of the normal yield curve to maintain its margins. Of course, a normal yield curve – characterized by lower yields for shorter-term maturities and progressively higher yields for longer-term maturities – is the most common and generally reflects a stable and expanding economy. As long as the curve stays inverted, the country’s financial institutions will not be able to make the ROAs that they have grown used to in recent years. The persistence of the inversion also continues to discourage financial firms from embracing the additional risk on longer-term loans. The leaders of these institutions might be a little more gun-shy too, with the most recent cycle marked by heavy mark-to-market investment losses in the AFS book for those who reached for additional yield at the longer end of the curve. Of course, that risk premium proved to be quite an inadequate amount of compensation for the additional term.

On the liabilities side of the balance sheet, the cost of funds at credit unions would normally be helped by the fact that more and more depositors are staying short. In normal times, this demand should push down the interest rate required to gather funds at the front end of the curve – offering some relief for the financial depositories that have been wrestling for deposits in a hyper-competitive environment. Unfortunately, the Treasury has continued to bring the supply of Treasuries with a duration mix that increases bills and shorter-dated notes and slows the pace of 10- and 30-year bond issues.

At the end of the day, the system of capitalism works best when there is a positive return for taking more risk with lending and investments further out on the curve. To get there, we are going to need to be confident that there is visible growth and quantifiable risks. In the words of Deutsche Bank’s Jim Reid, "the quicker we get back to a normal sloping yield curve the safer the system is."