Visualizing (and Understanding) an Inverted Yield Curve
For a few months in 2019, the yield curve inverted and warned of a potential recession.
Towards the end of 2021, it happened again. And throughout 2022, the inverted yield curve has looked more and more extreme. So what does an inverted yield curve look like, and what does it signal about an economy?
The above visualization from James Eagle shows the yield curve from November 2021-2022 using eurodollar futures yields—which serve as an indicator for the direction of the yield curve.
What Denotes an Inverted Yield Curve?
Generally speaking, the yield curve is a line chart that plots interest rates for bonds that have equal credit quality, but different maturity dates.
In normal economic conditions, investors are rewarded with higher interest rates for holding bonds over longer time periods, resulting in an upward sloping yield curve. This is because these longer returns factor in the risk of inflation or default over time.
So when interest rates on long-term bonds fall lower than those of short-term bonds, it results in an inverted yield curve.
The worrying trend is that an inverted yield curve in key government securities such as U.S. Treasuries can often foreshadow a recession. For every recession since 1960, an inverted yield curve took place roughly a year before, with just one exception in the mid-1960s.
This is because the yield curve has steep implications for financial markets. If the market predicts economic turbulence, and that interest rates will fall in the long term, investors flock to buy longer-dated bonds.
Eurodollars: A Hedging Tool
Let’s now look at eurodollar futures, as seen in the above visual.
Eurodollars are not to be confused with euros, the currency in the European Union. Instead, they are U.S. dollars held in term deposits outside of the United States. Originally it applied to accounts specifically in Europe, hence the “euro” prefix.
The video above charts eurodollar futures, which allow banks and companies to secure interest rates today for USD funds they plan to lend or borrow at a future date. In short, the yields on these futures can tell us how banks and companies around the world feel about interest rates—and economic strength.
How The Yield Curve’s Inversion Has Gotten More Extreme
The animation above clearly shows how the yield curve hasn’t just inverted, it has become more severe:
|Date||Yield Curve||Example Eurodollar Futures Yield|
|Jan-Feb 2022||Upward Sloping||Mar 2023: 1.3%
Mar 2024: 2.0%
|Mar-Aug 2022||Flat||Mar 2023: 2.5%
Mar 2024: 2.5%
|Sep-Nov 2022||Downward Sloping||Mar 2023: 5.0%
Mar 2024: 4.0%
As the above examples show, yields on March 2023 eurodollar futures contracts have continued to rise over the course of the year—from 1.3% to 5.0% by November.
Meanwhile, March 2024 eurodollar futures yields over the same time period began higher than their 2023 counterparts but eventually became eclipsed.
And more immediately, December 2022 eurodollar futures yields in November were much higher than 2024 yields. Not only does this indicate investor pessimism, it suggests that the market expects interest rates to fall by 2024 and for inflation to decline.
The Flip Side
On the other hand, market expectations of looser monetary policy in the future could miss the mark.
“I suspect the market is getting a little ahead of itself in terms of pricing in cuts… Central banks have still been talking about holding rates at higher levels for longer.”
– Andrew Ticehurst, rates strategist for Nomura Inc.
As 2023 unfolds, investors will be watching closely to see if the inverted yield curve indeed serves as a recession harbinger, and the wider consequences of this potential outcome.
This article was published as a part of Visual Capitalist's Creator Program, which features data-driven visuals from some of our favorite Creators around the world.
Recession Risk: Which Sectors are Least Vulnerable?
We show the sectors with the lowest exposure to recession risk—and the factors that drive their performance.
Recession Risk: Which Sectors are Least Vulnerable?
In the context of a potential recession, some sectors may be in better shape than others.
They share several fundamental qualities, including:
- Less cyclical exposure
- Lower rate sensitivity
- Higher cash levels
- Lower capital expenditures
With this in mind, the above chart looks at the sectors most resilient to recession risk and rising costs, using data from Allianz Trade.
Recession Risk, by Sector
As slower growth and rising rates put pressure on corporate margins and the cost of capital, we can see in the table below that this has impacted some sectors more than others in the last year:
|Sector||Margin (p.p. change)
|🏡 Household Equipment||-0.9|
|🚗 Automotive Manufacturers||-1.1|
|🏭 Machinery & Equipment||-1.1|
|🖥️ Computers & Telecom||-2.0|
*Percentage point changes 2021- 2022.
Generally speaking, the retail sector has been shielded from recession risk and higher prices. In 2023, accelerated consumer spending and a strong labor market has supported retail sales, which have trended higher since 2021. Consumer spending makes up roughly two-thirds of the U.S. economy.
Sectors including chemicals and pharmaceuticals have traditionally been more resistant to market turbulence, but have fared worse than others more recently.
In theory, sectors including construction, metals, and automotives are often rate-sensitive and have high capital expenditures. Yet, what we have seen in the last year is that many of these sectors have been able to withstand margin pressures fairly well in spite of tightening credit conditions as seen in the table above.
What to Watch: Corporate Margins in Perspective
One salient feature of the current market environment is that corporate profit margins have approached historic highs.
As the above chart shows, after-tax profit margins for non-financial corporations hovered over 14% in 2022, the highest post-WWII. In fact, this trend has been increasing over the past two decades.
According to a recent paper, firms have used their market power to increase prices. As a result, this offset margin pressures, even as sales volume declined.
Overall, we can see that corporate profit margins are higher than pre-pandemic levels. Sectors focused on essential goods to the consumer were able to make price hikes as consumers purchased familiar brands and products.
Adding to stronger margins were demand shocks that stemmed from supply chain disruptions. The auto sector, for example, saw companies raise prices without the fear of diminishing market share. All of these factors have likely built up a buffer to help reduce future recession risk.
Sector Fundamentals Looking Ahead
How are corporate metrics looking in 2023?
In the first quarter of 2023, S&P 500 earnings fell almost 4%. It was the second consecutive quarter of declining earnings for the index. Despite slower growth, the S&P 500 is up roughly 15% from lows seen in October.
Yet according to an April survey from the Bank of America, global fund managers are overwhelmingly bearish, highlighting contradictions in the market.
For health care and utilities sectors, the vast majority of companies in the index are beating revenue estimates in 2023. Over the last 30 years, these defensive sectors have also tended to outperform other sectors during a downturn, along with consumer staples. Investors seek them out due to their strong balance sheets and profitability during market stress.
|S&P 500 Sector||Percent of Companies With Revenues Above Estimates (Q1 2023)|
|Real Estate ||81%|
Cyclical sectors, such as financials and industrials tend to perform worse. We can see this today with turmoil in the banking system, as bank stocks remain sensitive to interest rate hikes. Making matters worse, the spillover from rising rates may still take time to materialize.
Defensive sectors like health care, staples, and utilities could be less vulnerable to recession risk. Lower correlation to economic cycles, lower rate-sensitivity, higher cash buffers, and lower capital expenditures are all key factors that support their resilience.
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