The U-shaped yield curve: a rare signal with significant implications

What is a U-shaped yield curve?

A U-shaped curve presents high short-term rates, a dip in the one- to two-year tenor, and then a directional change to higher rates at the long end. Today’s U-shape, defined as the average of the two-year/ten-year differential and the two-year/six-month T-bill differential, is particularly pronounced at nearly 45 bps.

How unusual is a U-shaped yield curve?

A typical yield curve, one we see about 80% of the time, is an upward-sloping or “contango” curve, where short-term rates are low and long-term rates are higher. This profile generally reflects healthy economic growth and a stable financial system. Conversely, an inverted or “backwardated” curve, where short-term rates are higher than long-term rates, occurs in about 9% of the observations and often signals an economic recession. A flat curve, which often indicates a market in transition, occurs another 8% of the time. A U-shaped curve, however, has occurred only about 3% of the time over the past 50 years, according to FRED data.

When have there been U-shaped yield curves?

U-shaped curves tend to precede significant financial disruptions, including the Asian and Russian Financial crises in 1998, the Dot-com bubble crash of 2000, the Great Financial Crisis (GFC) in 2007, pre-COVID starting late in 2019, and since the end of 2024. These periods spanned roughly 16 weeks with an average U-shape of 30 bps and a maximum of 65 bps prior to the GFC. Nearly every U-shaped period immediately preceded a recession, and the U-shape was resolved by a significant reduction in short-term policy rates, often between Fed meetings.

What does the U-shaped curve imply about future rates?

Evaluating the forward curve illustrates the market indication for a rapid decline in short-term rates, followed by a reversal into quickly increasing short-term rates. As a result of the arithmetic that underpins forward curves, it is highly unusual for these market predictors of future rates to change direction, as they do in a U-shaped curve environment. Specifically, short-term rates are predicted to decline as with an inverted yield curve in the near term, indicating recession, followed by a turnaround and economic recovery in the longer term.

What’s driving the U-shape?

One perspective on this curve shape is the juxtaposition of short-term policy against market participants with a view on the longer-term market. This disconnect between policymakers and the financial markets is more often found in the FX markets and is sometimes referred to as a “speculative consensus.” Some of the most well-known are 1992’s Black Wednesday, which effectively forced the U.K. out of the European exchange rate mechanism, the 1998 Russian ruble crisis, and the 2015 Swiss franc unpeg. Some might also argue that the 2021 GameStop short squeeze is an equity version of a speculative consensus.

How does the U-shape curve resolve?

Generally speaking, a speculative consensus resolves itself through a binary outcome — one side capitulates to the other. In the current rate environment, the binary outcome is likely either (1) a significant reduction in short-term rates to return to a more common steep curve, or (2) a short end anchored by current rates and a significant shift upward in long-term rates. Either of these outcomes could be expected to occur quickly and decisively.

Should borrowers be fixed or floating?

For borrowers, this U-shaped curve presents unique challenges. Historically, floating-rate borrowing has been significantly less expensive than fixed-rate debt. Over the past two years, short-term floating rates have been more expensive than longer-term borrowing. So, maintaining floating rate positions and waiting to benefit from a short-term rate decline has been an expensive proposition. Even though fixed-rate borrowing has been less expensive than floating and provides more certainty, some borrowers have resisted locking in fixed rates while waiting for even lower rates.

What tenor should investors buy?

For investors, the U-shaped curve creates different challenges. Holding a larger cash allocation provides a respectable return, and extending to longer tenors reduces returns unless the investor takes on much larger duration risk by investing out on the curve. This evaluation of yield pick-up for duration is also impacted by the U-shape curve. In a typical steep-yield-curve environment, investors will often demonstrate a pro rata perspective on medium- and longer-term tenors. However, looking at bond offerings back in March when the U-shape was relatively modest, investors seemed to prefer the shorter duration tenors since the yield pick-up for longer term was limited. As the U-shape has increased over the past six weeks, investors seem to have preferred longer duration tenors for the more material yield pick-ups.

Planning for binary market outcomes

So, what can you do to prepare for a potential binary market outcome?

1. Be aware: Recognize the unique environment and the potential outcomes to begin planning.
2. Role play: Understand the motivations, constraints, and interests of those on the other side.
3. Scenario plan: Consider the implications and risks for each path.
4. Mitigate risk: Implement strategies to create certainty and reduce the impact of systemic risks.
5. Hold on tight: Speculative consensuses have not historically worked out smoothly.

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