Is an inverted yield curve here to stay and what does that mean?

Inverted Yield Curve with aerial view of New York City

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The yield curve between the 2-year and 10-year Treasury notes has inverted again to start Friday’s session, a closely watched indicator that has historically been associated with eventual recessions.

While the curve has now flirted back and forth with inversion over the last several days, investors are looking to see what the dynamic signals and whether the condition is likely to persist over a meaningful period of time.

At the moment, the U.S. 10-year Treasury yield is up five basis points to 2.39%, whereas the U.S. 2-year Treasury yield is up twelve basis points to 2.45%.

Inversion describes a situation where the longer-duration bond has a lower yield than the shorter-duration one. This represents the opposite condition than usual, as investors typically ask for additional return when locking up their cash for a longer period of time. Thus, under normal conditions, long-duration bonds generally have higher rates than those with shorter durations.

The concern surrounding inversion centers around the idea of a potential future recession.

Historical precedent indicates that persistent inversions have been associated with eventual economic downturns. This situation took place in 2006-2007, when inversion presaged the Great Recession of 2008-2009. The circumstances also took place in 2000, pointing the way to the 2001-2003 stock market meltdown.

An elongated inversion can act as a precursor to the future of the economy. Given that investors are accepting lower returns for longer time periods, inversion indicates that they have become less optimistic about the future than they are about the present. As such, inversion suggests that market participants foresee potential headwinds ahead, including a possible recession.

In terms of investment options during the current market conditions, a handful of key exchange traded funds are sensitive to the price action of the yield curve. A handful of examples are listed below along with their YTD price action:

The iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG) -6%, Vanguard Total Bond Market ETF (NASDAQ:BND) -6.3%, iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) -9.3%, iShares 3-7 Year Treasury Bond ETF (IEI) -5.4%, iShares 7-10 Year Treasury Bond ETF (IEF) -6.6%, iShares Core U.S. Treasury Bond ETF (GOVT) -5.5%, and the Schwab U.S. Aggregate Bond ETF (SCHZ) -6.3%.

While rising yields have generally pushed Treasury-related ETFs lower, there are ways to use ETFs to capitalize on a rising-rate environment. Investors betting that yields will continue to rise should examine the ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA:TBT), which is +17.6% in 2022. TBT is constructed to bet against bond prices.

Additionally, see the below yield curve chart highlighting the recent moves. Weighing the possibility of an eventual downturn, Bank of America stated: "Recession risks are the topic du jour, but we view that as more of a risk for 2023." See the firm's full commentar in a recent market note.

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