What Happens When The Yield Curve Flattens And Potentially Inverts? Here's What To Watch And How To Trade It

The yield curve is simply the spread between long-term and short-term interest rates. Short-term rates tend to be more influenced by central banks and monetary policy to stimulate the economy, support employment and maintain price stability. Long-term rates are typically impacted by underlying supply and demand forces.

Yield Curve Explained: Under normal conditions, interest rates on longer-term debt are higher than rates on shorter-term debt. This phenomenon makes sense because there is an opportunity cost when investors tie up their money in bonds for 10 or 20 years instead of one or two years.

Investors often use the spread between 10-year U.S. Treasury yields and 2-year U.S. Treasury yields as a gauge of future growth or potential economic downturns. When the difference between the 10-year and 2-year yield is large, the yield curve is considered "steep." A steep yield curve suggests future economic growth. Under these conditions, investors believe there will be better long-term investment opportunities elsewhere in the economy, and they're unwilling to buy long-term bonds unless interest rates on them are relatively high.

When the spread between 10-year and 2-year Treasury yields is low, the yield curve is considered "flat." Under these conditions, investors don't anticipate significant future economic growth, and they're willing to commit money for the long-term at interest rates similar to the ones currently available.

Inverted Curve: Sometimes, yield curves can become inverted, a scenario in which short-term yields are higher than long-term yields. Inverted yield curves, also called negative yield curves, have historically occurred during periods of economic recession. Inverted yield curves have preceded each of the past 10 U.S. recessions, and have come between six months and 24 months before the beginning of the recession.

The yield curve last inverted in August 2019, about six months prior to the brief recession that began in February 2020.

After peaking at around 1.6% in March 2021, the yield curve has since been trending steadily lower as investors anticipate an aggressive Federal Reserve tightening cycle to stave off inflation. The yield curve now stands at just 0.42%.

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How To Play It: If the curve dips into negative territory, investors shouldn't panic. In fact, the SPDR S&P 500 ETF Trust SPY has historically performed relatively well during the year following a yield curve inversion.

Some stocks perform better than others when the yield curve is inverted. Bank stocks tend to struggle because banks profit by borrowing money in the short term and lending it in the long term.

If the yield curve inverts, investors can look for the SPDR S&P Bank ETF KBE to potentially underperform, At the same time, utility stocks have historically performed relatively well when there is an inverted yield curve. Utility sector ETFs, such as the Utilities Select Sector SPDR XLU might be a smart bet for investors the next time the yield curve inverts.