In the past few weeks the media have been talking about an “inverted yield curve” and why it may be an indicator of a coming recession.
For example, from USA Today: “One of the most closely watched predictors of a potential recession just yelped even louder.”1
As a well-informed investor who wants to avoid unnecessary losses on the road to retirement, you might want to know what the yield curve is and why so many people look to it as an economic indicator.
The yield curve is simply a line on a graph that compares the return rates at a given point in time of bonds with various lengths of maturity. The most frequently reported yield curve compares the three month, two-year, five-year, 10-year, and 30-year U.S. Treasuries.2
The shape of the curve connecting these points is used as an indicator of future interest rate changes and economic activity. When investors are optimistic about future economic growth, they tend to favor instruments like stocks and so must be paid a higher yield for longer term bonds—a premium for having their money tied up for a longer period. This results in a “normal” upward curve where bond yields are incrementally higher as maturities get longer.
But when investors are unsure about the future, they tend to abandon stocks, replacing them with things like lower risk Treasuries. As demand for long-term bonds increases, the rates they must pay to attract purchasers decreases. As a result, the line on the graph flattens out or even begins arcing downward in what’s described as an inverted yield curve.
Several weeks ago three-month Treasury bonds were yielding 2.45% while the 10-year bond was yielding only 2.43%.
According to USA Today, “The last time a three-month Treasury yielded more than a 10-year Treasury was in late 2006 and early 2007, before the Great Recession made landfall in December 2007.”
Is this a sure sign that a recession is coming? No one knows for certain though you can certainly find lots of people claiming they do.
It’s important to remember that the yield curve is simply a snapshot of investor sentiment, just another measure of market activity. Sometimes it’s an indicator of an impending recession. But sometimes it’s not, as was the case with the inversion of 1966.
Frances Donald, head of macroeconomic strategy at Manulife Asset Management says that it’s a sign to take seriously, but “it’s too early to tell whether this is indeed a harbinger of recession or a blip.”
Some doubts about our current curve as an indicator include the fact that parts of the curve aren’t inverted. And late last year the Federal Reserve Bank of Richmond issued a paper questioning whether central bank asset purchases have “tempered the reliability” of the yield curve as a future indicator.3
While the yield curve as a measuring tool itself is the same, the circumstances today in bond markets are very distinct from previous inversion periods. For example, the Federal Reserve’s Quantitative Easing [QE] policy for nearly a decade is finally being unwound with incremental interest rate hikes. Interest rate hikes are nothing new. But the QE conditions from 2008 to 2017 were arguably an unprecedented market condition. So maybe today’s yield curve does or doesn’t look like others in history for completely different reasons.
Additionally, because the yield curve is so influential, news of its inversion may lead to a self-fulfilling prophecy. “We’re so accustomed to this telling us a recession is ahead,” says Donald, “that my concern is businesses and households get so scared they effectively create one.”
Since there is no completely reliable indicator of future market behavior, as a prudent investor you should make allowances for all possible activity, both run-ups and recessions, through a globally diverse strategy.
Your trusted advisor can help you create a plan that takes all this into account, and then help you stick to it as you progress confidently toward your investment and retirement goals.
Citations:
1 – https://www.usatoday.com/story/money/markets/2019/03/22/why-inverted-yield-curve-bad-its-potential-recession-signal/3246907002/
2 – https://www.investopedia.com/terms/y/yieldcurve.asp
3 – https://www.richmondfed.org/-/media/richmondfedorg/publications/research/economic_brief/2018/pdf/eb_18-12.pdf