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The Yield Curve Is Inverted: Should Lenders Care?

By Rob Chrisman, Senior Advisor

The U.S. Treasury Curve is currently “inverted.” What does that mean? Should it matter to lenders? The fact is, the yield curve (a graphical representation of yields, usually of U.S. Treasury or government-backed securities, stretching from overnight to 30 years) has been inverted for several months, and yet the sun continues to rise in the east, geese head north for the summer, and the economy has not ground to a standstill. But what is the “yield curve,” what exactly does an inverted yield curve mean, and what are the implications for lenders?

Let’s start with the basics. Traditionally, shorter-term securities have lower rates and long-term have higher rates because obviously someone wants to be paid more if they are going to tie up their money for longer. Loan officers know that adjustable-rate mortgage rates are usually lower than 15-year mortgages. This is important to lenders because bond traders and investors base their decision making (what to buy or sell, and at what price) on mortgage securities based on a spread to Treasury securities.

Being inverted means that short-term treasury yields (the one-year, two-year, and three-year) have higher rates of return (aka “yield”) than, say, the 10-year or 30-year do. This is counter intuitive, since the longer you give someone your money for, the higher rate of return you would expect. And this is what normally happens unless you’re entering a period of economic uncertainty. In periods of economic uncertainty, it makes sense to have an “inversion” of the yield curve: short-maturity interest rates exceed long-maturity rates typically associated with a recession in the near future.

Put another way, in “normal market conditions,” as a compensation for higher risk, thousands of investors expect higher rates of interest for money they lend over a longer time horizon. This is traditionally reflected in an upward sloping treasury curve. When it inverts, investors are more apprehensive about the long term than they are about the short term. They believe a recession is imminent. Short-dated deposits, bills and notes offer higher yields than those on longer-dated bonds. But lenders should know that when the economy slows down, rates go down.

Yield curves are upward sloping to compensate investors for the added risk of tying up their money for longer periods. Longer-term bonds carry greater risk of various potential losses, ranging from inflation to default. Investors therefore normally require an additional return, in the form of higher yields, to offset the risks of venturing out along the yield curve. A yield-curve inversion does not cause a recession. Instead, the slope reflects changing expectations about the economy, and these expectations are useful predictors of economic downturns.

As of late, investors have bought or sold treasuries and mortgage-backed securities, depending on what they think is going to happen to inflation. It is generally assumed that prices will increasingly rise in the years ahead, and investors need to be compensated for bearing that risk, since higher inflation will erode their future purchasing power. For this reason, bond yields contain an element of inflation premium, normally with an increasingly higher premium for bonds with longer maturity dates.

Lenders and originators should also know that the yield curve is influenced by more than monetary policy expectations. The shape and slope of the yield curve also reflect market attitudes toward various risks, and these too are influenced by economic outcomes. Interest rates on long-term securities reflect expectations of what might happen during the life of the bond, or mortgage. In other words, investors shy away from paying a premium price above 100 (par) for mortgages with high rates, assuming that at some point the borrower will refinance because rates have dropped. Why pay 103 for something that will return 100 in six months? We saw this phenomenon on rate sheets in the Spring of 2022: no one wanted to pay above par.

If investors expect a downturn, they likely also anticipate that the Federal Open Market Committee (FOMC) will cut the future policy rate to provide monetary policy accommodation. The expectation of lower future rates reduces longer-term rates, and this could result in an inverted yield curve. Any aggressive monetary policy tightening by the FOMC, which would push up current rates relative to future ones, heightens the odds of a future decline in economic activity leading to overall lower rates, including mortgage rates.

Keep in mind that no one owns a crystal ball with a clear view of the future, and that the slope of the yield curve is not the only indicator of potential future economic activity. Stock prices, and their dividend streams, are often mentioned. The Commerce Department’s (now the Conference Board’s) index of leading economic indicators appears to have an established performance record in predicting real economic activity.

Yield curve inversion is not a lasting feature of the capital markets landscape. Know that whenever the yield curve is inverted, investors have already begun to anticipate its “normalization” which typically takes place in the context of falling interest rates, what Wall Street terms a “bull steepening.” In those instances, both short- and long-term interest rates fall, with the front end (shorter-dated maturities) rallying more than the long end. A bull steepening is bullish for fixed income markets, including mortgage rates.

Lenders and originators should keep in mind that yield curve normalization will only take place once the economy softens. Lenders know that a soft economy, however, can impact the percentage of borrowers that qualify. But a soft economy might be far in the future given the very tight labor market: unemployment is not going down. For now, 30-year fixed rates are clustered around six percent, and this may be the norm for quite some time.

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