Yield Curve Inversion Spooks Markets: 5 Utility Picks

On Dec 4, U.S. markets suffered their worst reversal since October with investors waking up to a brand new headwind. For the first time in more than a decade, yields on Treasuries with shorter maturities exceeded longer-dated issues on Dec 3. In other words, the yield curve experienced an inversion. Traditionally, such a phenomenon heralds the coming of a severe economic downturn.

The trend continued into Tuesday and is likely to prevail in an environment where the Federal Reserve is firm on tightening the monetary environment. Utilities stocks were the biggest gainers of yesterday’s trading session.

Their superior diving yields and steady revenues make them good choices in a tough economic environment. Investing in this class of stocks would make for a smart move right now.

Why Does Yield Curve Inversion Happen?

On Dec 3, the yield on the three-year Treasury note exceeded the return on its five-year counterpart for the first time since 2007. The phenomenon continued on Dec 4, with the yield on the 2-year Treasury note surpassing the return on the 5-year note. Yields on other longer-dated securities tumbled, with the 10-year Treasury yield falling below 3%.

With returns on shorter duration securities exceeding those with longer maturity periods, the yield curve has inverted. This brings us to the yield curve itself, a graph of rates payable by government bonds until the principal amount has been paid. Usually, this graph slopes upward since long-term rates exceed short-term returns.

This means that when the yield curve inverts, short-term rates are exceeding their long-term counterparts. In other words, long-term bonds are in high demand, a phenomenon which pushes down their yields. This is because investors are taking a negative view of short-term economic prospects. 

Does This Imply that a Recession is Up Ahead?

For this very reason, an inverted yield curve has historically been a reliable indicator of recession. But optimists think that the most crucial yield gap, the one between the 3-month and 1-year government notes has not inverted. They take this to imply that an economic downturn is unlikely in the near future.

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