What’s the yield curve?

Beyond bond market specialists, the yield curve doesn’t usually get much attention from investors—except when there’s trouble. But when its shape contorts in a way that suggests the economy is entering a rough patch—or perhaps even veering toward a recession—the yield curve is suddenly thrust into the spotlight. That was the case in 2022, when it initially made headlines by doing something quite rare: one segment of the curve inverted as the yield of the 2-year Government of Canada bond trended above the 10-year yield.

What’s the yield curve and what should bond investors make of the warning it just sent?

Spurred in large part by the Bank of Canada’s aggressive rate-hiking cycle, the inversion initially happened in July 2022. The 2-year Government of Canada bond yield climbed to 3.25%, nudging past the 10-year yield of 3.24%. Since that occurrence, the yield on the 2-year issue has drifted beyond that of the Government of Canada’s 10-year equivalent, sending a potential signal to markets.

The shape of Canada’s yield curve has shifted rapidly since 2022

Yields on Government of Canada bonds of varying maturities on two selected dates (%)

Graph showing the steep inversion of the yield curve since its initial inversion in the summer of 2022. Graph showing the steep inversion of the yield curve since its initial inversion in the summer of 2022.

Source: Bank of Canada, as of April 20, 2023

Yield curve basics

Why should investors care when the yield curve flattens or inverts, and what might the recent inversion mean for the economy? First, it’s important to understand what constitutes a normal shape—or progression—for bonds of various maturities.

The yield curve reflects the relative differences in yields that bonds of various maturities pay. Normally, if other characteristics—such as credit quality—are equal, a bond with a 2-year maturity would be expected to pay a lower yield than a 10-year bond. That’s the case across the spectrum; just as a 1-month bill is likely to pay a lower yield than a 1-year bill, a 10-year issue is likely to pay less than a 30-year issue.

This yield differential reflects the fact that the longer a bond’s maturity, the greater the potential that a period of rising interest rates could leave the bondholder with a fixed yield that’s lower than the going rate for newly issued bonds. For example, if rates rise from 2% to 3% for 10-year Government of Canada bonds, then previously issued 10-year issues paying 2% interest become less attractive. (Similar to maturity, a bond’s duration is a measure of how much its price is likely to change given a corresponding change in interest rates.)

Typically, when Canada’s economic growth is solid, the yield curve rises with each step up the bond maturity scale. For example, on January 4, 2022, the 1-month Government of Canada bill had a yield of 0.08%; for the 2-year issue, the yield was 1.01%; for the 10-year issue, it was 1.59%.

What happens when the yield curve inverts?

When a bond’s yield rises above that of a longer-dated bond that has equal characteristics (credit quality, optionality, etc.), that portion of the overall yield curve is said to be inverted. While the spread between the 2- and 10-year bonds often gets the most attention from investors, an inversion can also occur elsewhere on the curve and across a wide range of maturities. For example, the 3-month to 10-year portion of the curve has been inverted since November 2022. The spread between the yields on 3-month and 10-year Government of Canada bonds has also turned negative prior to each of the preceding two economic recessions.

The yield curve inverted on a few occasions over the last five years

Tracking the daily yield spreads on 2- and 10-year Government of Canada bonds in basis points

Chart showing the spread between 2-year and 10-year Government of Canada bonds over time. Chart showing the spread between 2-year and 10-year Government of Canada bonds over time.

Source: Statistics Canada, as of April 24, 2023. One hundred basis points (bps) equals 1%.

Going back further, a protracted inversion of the 2- and 10-year yields ended in August 2007, roughly 14 months before Canada began to feel the effects of the 2008 Global Financial Crisis and a recession was declared.

Yield curve inversions have been rare over the last 20 years

Tracking the daily yield spreads on 2- and 10-year Government of Canada bonds in basis points

Chart showing the spread between 2-year and 10-year Government of Canada bonds over time. Chart showing the spread between 2-year and 10-year Government of Canada bonds over time.

Source: Statistics Canada, as of April 24, 2023. One hundred basis points (bps) equals 1%.

Links between yield curve inversion, the economy, and the markets

Aside from the implications for fixed-income investors, a yield curve inversion attracts attention because past inversions have often preceded recessions and, therefore, may be seen as warning signs for investors across asset classes, including stocks.

The inversion in 2022 came during a challenging stretch for the global economy amid Russia’s invasion of Ukraine and sharply rising commodity prices. In Canada, the labour market and economic growth were strong, but inflation had surged to the highest levels in more than four decades. In response, the Bank of Canada (BoC) responded aggressively by raising its benchmark rate on eight separate occasions.

Throughout 2022, the Bank of Canada’s unprecedented rate-hiking cycle prompted investors to sell 2-year notes, as their yields became less attractive in the face of rates resetting higher (as those bonds approached maturity in an economy facing plenty of headwinds). As a result, yields of newly issued 2-year Government of Canada bonds surged to adjust to the new rates.

In contrast, longer-dated bonds, such as 10-year Government of Canada bonds, were relatively steady over the same period, as their longer durations made them less vulnerable to near-term shifts in monetary policy and the economy. Short-term adjustments to the policy and economic outlook had a far greater impact on the 2-year segment of the yield curve than on other durations, causing a steep inversion that is still very much pronounced today.

What to watch going forward

It’s hard to say whether this prolonged yield curve inversion implies economic conditions will deteriorate going forward. While inverted yield curves generally reflect market expectations that hard times are ahead, predicting the future will never be an exact science. It’s true that yield curve inversions tend to precede recessions historically, but whether they can be relied on as reliable recession predictors is up for debate. That’s why it’s important to properly diversify your portfolio and rely on multiple indicators to help you paint a more accurate picture.




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