Markets are still ignoring inverted yield curve

If you consider yourself an educated investor, there are two things you may already know about an inverted yield curve. First, it describes a period in which short-term bonds offer higher interest rates than longer-term bonds. Second, it has historically been a reliable indicator of a coming economic recession.

That might be good enough to correctly answer a "Jeopardy" clue, but it doesn't explain the real-world impacts. This column attempts to fill in the gaps.

The yield curve is currently inverted and has been for more than a year. That is to say, for the last 12 months, two-year U.S. Treasury bonds have yielded more than 10-year U.S. Treasury bonds. One of the most significant effects of these conditions is the pressure it puts on the banking system.

In a normal interest rate environment, banks make money on the spread between short-term rates (paid out to depositors) and longer-term rates (collected from borrowers who take out a loan). That business model breaks down when the yield curve inverts. As a result, banks often compensate by paying "below market rate" interest to depositors to avoid losing money.

This tends to be permissible for short periods of time, but the longer the inversion lasts, the larger the financial consequences.

The failure of Silicon Valley Bank was related to a true mismanagement of risk by the company's decision-makers. But the ensuing panic and cascading effects on the regional banking sector was exponentially worse because the returns offered by local banks were suddenly more risky and lower-yielding than the alternatives.

Another option banks may consider is to reduce lending, which creates a "credit crunch." For corporations, this makes it more difficult to borrow money and finance growth. Eventually, it contributes to a slowdown in economic activity. For consumers, less competition among banks means a higher cost of borrowing.

The stock market, meanwhile, appears totally unconcerned by the inverted yield curve despite its track record of predicting recessions. In one sense, that's understandable because inverted rates suggest inflation will be lower in the future than it is today. Stock momentum continues to build. And in terms of seasonality, July-September has been strong in the last 20 years.

At some point, however, rising bond yields across the board become problematic for equities. Whether it's short-term or long-term bonds, higher yields create an attractive lower-risk investment. More importantly, the types of stocks that have led this rally (Big Tech and high growth) typically underperform when bond yields are rising.

The 10-year Treasury yield rose above 4% in early July and it's inconsistent with historical performance to suggest Tech stocks will continue leading the rally given what is happening with bonds. Evolving conditions probably warrant a pivot toward other industries.

We are still optimistic about this economic recovery but even if we are fortunate to avoid a recession, the fallout from an inverted yield curve needs to be considered in your investment decisions.