By now, many have heard about the inverted yield curve and the impending disaster predicted to follow within the next 12 months. This broad window of looming disaster is the perfect headline to keep viewers glued to TVs and give pundits the ratings boost they need.
Yet, with all the news coverage, many are still asking, “What is an inverted yield curve and why does it matter?” The yield curve is a line made of plotted data points, in this case the interest rate of various maturing bonds. Commonly tracked yield curves are the three-month, two-year, 10-year, and 30-year US Treasury notes. These yields are the basis of setting other benchmarks such as mortagage lending rates and bank loan rates. The shape and movement of the yield curve is also tracked as a tool for predicting the future of the market.
In a normal (positive) yield curve, the interest rate offered on short-term bonds is lower than the rate offered on long-term bonds. Theoretically, it makes sense to get paid more for longer-term bonds because you’re taking more risk by locking your money up for a longer period of time. For example, you could lock in a current market return of 2% for 10-years and the going market rate could rise to 5% in the middle of your 10-year investment window creating opportunity loss. A normal yield curve is most commonly associated with positive economic growth.
An inverted or negative yield curve occurs when the interest rates offered on short-term bonds are greater than the rates offered on long-term bonds. Often, this happens because investors are wary of the future market and migrate out of stocks and into bonds. This drives the return on long-term bonds down as investors are willing to take a lower return to avoid downside risk in equities. An inverted yield curve has historically been seen (but not always) before a recession. Therefore an inverted yield curve has negative sentiment and is feared by market watchers.
Historically, an inverted yield curve has preceded the last seven recessions dating back to the 1960’s. Most recently, the U.S. Treasury yield curve inverted in 2006 prior to the Great Recession in 2008.[i] However, there have been two false indications of a recession also – an inverted yield curve in 1966 that was followed by economic growth and 1998[ii], a flat yield curve, similar to the one we are currently experiencing.
The question on everyone’s mind is, “Are we going into another recession?” The most common indicators of a recession haven’t occurred – A high GDP growth rate hasn’t happened in our long slow recovery from the Great Recession, we do not have rising unemployment, nor spiking interest rates. Additionally, some market analysts state that the interest rates on long-term bonds is no longer indicative of market demand due to large, steady foreign investments in U.S. Treasuries. These sustained purchases create a simple supply and demand condition that drives down long-term U.S. debt, regardless of the current or future market environment[iii].
Keep in mind that the yield inversion that occurred on Friday, March 22nd was a mere 0.035% crossing of the 3-month and 10-year Treasury bonds[iv]. A recession could hit later this year, or in the next few years to come. Some investors are considering whether now is the right time to cash out and wait on the sidelines; ready to jump back in right as the economy shifts upwards again. The concept sounds great, in theory, but few if any have become overnight millionaires executing this strategy perfectly.
A sounder and more logical approach to market downturns is to limit your risk exposure by balancing asset classes. Rather than having all your eggs in one basket, implement an investment allocation that balances your exposure in large and small US companies, large and small international companies and balances your equity exposure with high-quality fixed income to shield you on the downside when equities lose value. This dependable approach to investing not only reduces your portfolio volatility, but allows you to stay invested during difficult periods in the market so you can capture gains when the market recovers.
At the end of 2018, people were already throwing around the term “tech-wreck” and cashing out their portfolios, referencing the Dot-com crash of 2000. Just two months later, the S&P 500 booked the best January dating back to 1987[v]. It goes to show, market downturns and recoveries can happen very quickly. Chasing the market can be an emotional rollercoaster that hurts your heart and your wallet in the end. If you need a second opinion on your current investment portfolio, reach out to a financial advisor who is a Fiduciary and will put your best interest first.