Fixed income strategies in times of an inverted yield curve

‌2 / Historical returns during inverted yield curve environments

2.1 Findings from the United States bond market

Since the 1970s, the Fed has engaged in six interest rate hiking cycles including the current cycle. Inverted yield curve environments are not without precedent, and in fact have occurred with some frequency throughout modern history during these periods of aggressive interest rate hiking. Generally speaking, however, inverted yield curve environments have rarely persisted for more than a few quarters. The current inverted yield curve regime has lasted roughly a year to this point and is already the second longest such continuous period over our time series, second only to September 1980 to September 1981.

In order to illustrate these periods of yield curve inversion, we compare the 10-year US Treasury yield to the 2-year US Treasury yield, the latter being a less volatile measure of both the point-in-time level of short-term interest rates and the trajectory of said rates over the subsequent 2 years. Chart 4 shows the 10-year and 2-year Treasury yields and highlights the periods where the 2-year yield exceeded the 10-year yield.

Chart 4: U.S. Treasury 10-2 yield curve and inversion

^{Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 9/20/23 Data from 31st May 1976 to 30th June 2023}

In an inverted yield curve environment, investors face the question of whether it is a better strategy to take advantage of nominally higher interest rates by investing in short-term securities, but running the risk of reinvestment at worse conditions, or to lock in a lower yield for a longer period. In the following section, we examine what conclusions can be drawn from the historical performance of short-term money market investments, medium-term (5-year) bond investments, and long-term bond investments. In a first step, we examine the experience in the U.S. bond market, and in a second step take a look at the German Bund market.

During these inverted yield curve environments, quite intuitively, the average monthly return for 30-Day T-Bills exceeded longer-tenor US Treasuries, although interestingly the differential between T-Bills and 5-year US Treasuries is quite small.

Chart 5: Average monthly returns during inverted 10-2 periods

^{Sources: Morningstar Direct, DWS Investment GmbH as of 9/20/23 DWS calculation from 31st May 1976 to 30th June 2023}

When looking over a medium-to-longer time horizon, this return differential between short duration and longer duration Treasuries fades rather quickly. Over 3-, 5-, and 10-year rolling periods, the subsequent average annualized returns of different duration Treasuries during periods of yield curve inversion shows significantly higher average subsequent returns of 5-year and 20-year US Treasuries relative to 30-day T-Bills.

Chart 6: Average subsequent 3-year returns during inverted 10-2 periods, annualized

^{*average 3-year rolling return, annualised DWS calculation from 31st May 1976 to 30th June 2023}

^{Sources: Morningstar Direct, DWS Investment GmbH as of 9/20/23}

Chart 7: Average subsequent 5-year returns during inverted 10-2 periods, annualized

*average 5-year rolling return, annualized DWS calculation from 31st May 1976 to 30th June 2023

^{Sources: Morningstar Direct, DWS Investment GmbH as of 9/20/23}

Chart 8: Average subsequent 10-year returns during inverted 10-2 periods, annualized

^{*average 5-year rolling return, annualized DWS calculation from 31st May 1976 to 30th June 2023}

^{Sources: Morningstar Direct, DWS Investment GmbH as of 9/20/23}

 

As we approach the end of the current Fed hiking cycle, we can also analyze how different tenor US Treasuries performed subsequent to the peak in short-term interest rates.

Over our time series, from May 1976 to June 2023, there have been, apart from temporary inversions, 4-major regimes of inversion between 10-year and 2-year US Treasury yields highlighted in Chart 4. Following the point of the most negative spread between 10-year and 2-year U.S. Treasuries, we can examine the subsequent returns across different tenor Treasuries. Chart 9 illustrates that longer-duration US Treasuries have outperformed T-bills quite significantly over 3-, 5-, and 10-year periods following the peak in yield curve inversion.

Chart 9: Subsequent returns during peak inverted 10-2 periods, annualized (%)

	Peak inversion date	30-day Treasury bills	5-year U.S. Treasury	20-year U.S. Treasury
Next 3 years	2/29/1980	12.00%	17.70%	16.50%
	3/31/1989	6.90%	11.40%	12.40%
	3/31/2000	3.40%	10.50%	11.20%
	11/30/2006	2.20%	7.30%	6.90%
Next 5 years	2/29/1980	10.90%	14.30%	12.20%
	3/31/1989	5.40%	10.20%	12.10%
	3/31/2000	2.50%	6.70%	8.70%
	11/30/2006	1.40%	7.00%	9.40%
Next 10 years	2/29/1980	8.80%	12.70%	13.60%
	3/31/1989	5.20%	8.50%	11.00%
	3/31/2000	2.60%	6.10%	6.90%
	11/30/2006	0.70%	4.20%	6.40%

^{Sources: Morningstar Direct, DWS Investment GmbH as of 9/20/23 DWS calculation from 31st May 1976 to 30th June 2023}

 

2.2 Findings from the German Bund market

Looking back to the establishment of the European Monetary Union, the German bund market has experienced three inverted yield curve regimes since September 1972 including the current regime. The previous two regimes lasted roughly three years on average, although the most recent period of yield curve inversion was not continuous, while the current inverted yield curve began in November of 2022. Chart 10 shows the periods of inversion between the 10-year and 2-year German Bund yields.

Chart 10: German Bund 10-2 yield curve and inversion

^{Sources: Deutsche Bundesbank, DWS Investment GmbH as of 9/20/23 DWS calculation from 1976 to 30th June 2023}

During these previous two periods of inversion between 10-year and 2-year German Bund yields, the subsequent 3-, 5-, and 10-year returns were on average, higher for longer-tenor bonds despite higher short-term rates during the investment period. Chart 11 shows the average annualized returns of different tenor bonds across these subsequent timeframes.

Chart 11: Average annualised returns during inverted 10-2 periods

^{*annualized return DWS calculation from 30th September 1972 to 30th June 2023}

^{Sources: Deutsche Bundesbank, DWS Investment GmbH as of 9/20/23}

Looking specifically at the point of most negative spread between the 10-year and 2-year German Bund yields, Chart 12 shows that subsequent 3-, 5-, and 10-year returns were higher for medium-to-long-term bonds relative to shorter-duration fixed income.

Chart 12: Subsequent returns during peak inverted 10-2 periods, annualized (%)

	Peak inversion date	30-day Treasury bills	5-year U.S. Treasury	20-year U.S. Treasury
Next 3 years	8/31/1981	11.77%	13.57%	13.44%
	7/31/1992	8.70%	10.03%	9.49%
Next 5 years	8/31/1981	10.60%	13.16%	14.46%
	7/31/1992	7.79%	10.36%	10.77%
Next 10 years	8/31/1981	7.86%	8.78%	8.84%
	7/31/1992	6.00%	7.76%	8.70%

^{Sources: Deutsche Bundesbank, DWS Investment GmbH as of 9/20/23 DWS calculation from 30th September 1972 to 30th June 2023}