Another Bond Yield Inversion—Now What?

Another day, another inversion in the Treasurys market, when a shorter-term government security  commands a higher interest rate than a longer-term one. It’s considered one potential warning sign of a recession.

There are multiple potential matchups of these government bonds. The pairings that tend to get the most attention are the 3-month-to-10-year, as just happened, and the 2-year-to-10-year, which inverted in July and has been upside down since.

“Historically, such an inversion has typically preceded economic downturns and therefore is taken as a warning sign,” Ryan Severino, JLL chief economist, tells GlobeSt.com. “Some economists think the 3 month-10 year is the gold standard [as an inflation sign]. Other economists look at other inversions. Some look at multiple. But none will take this as a positive sign.”

The theory is that usually investors demand higher interest rates for investments with maturities that don’t come due for longer periods. It’s an expected premium. However, when shorter-term bonds command higher interest than longer-term ones, the same investors are telegraphing effectively saying that they have more confidence in the near future than mid- to longer-term and expect economic conditions to get worse. So, they want higher interest rates in the short run to tie up their money in what they see as turbulent times with more perceived risk.

“What does the 10-year rate really represent? It is the level at which you would be indifferent—on a present value basis—between paying a constant rate for 10 years or floating for 10 years based on the current forward curve,” says Kevin Swill, CEO of Thirty Capital Financial. “If 3-month rates are higher than 10-year rates, then the market assumes that floating rates are due to fall not only to the 10-year rates, but below the 10-year rate over the course of the next 10 years.”

The predictive power of inversions isn’t always accurate. If a recession occurs, it can take six months to a couple of years for that presence to be felt, and there are times when a recession doesn’t follow a yield inversion.

There are also times when it’s tough to comment on the predictive power. In 2019, there was a yield inversion from May to October. A recession did eventually happen, but it was triggered by the pandemic, which was outside of the normal economic forces. Would a recession have happened anyway? Impossible to know.

For commercial real estate, the potential effects vary. “The short-term cost of funds will increase but for fixed-notes, there will be no effect,” says Todd Parriott, CEO and founder of Connect Invest. The effect on particularly investors and projects will depend on where their financing stands.

But valuations could take a hit. “Cost of debt for real estate has gone from the mid-3% level at the beginning of the year to more like 5.5% to 6% today and there’s capital rationing happening across the debt markets,” says Uma Moriarity, senior investment strategy analyst and global ESG lead of CenterSquare Investment Management. “REITs have effectively already priced in the impact of the changing reality of debt costs. That price correction has not happened in the private markets yet, and we anticipate that is coming in the next 12 months.”

“There is value for buyers, with nominal spreads of a 30-year [mortgage-backed security] MBS to a 5-year/10-year blend widening to 174 bp,” adds Justin Hoogendoorn, head of fixed income strategy and analytics at Hilltop Securities. “This has only been matched very briefly during COVID and then during the Financial Crisis.”

However, it’s important to remember that ultimately tenants need the income to pay the rents that make CRE work. How they would fare in a recession might be a different matter.