There is a lot of talk in financial circles about the inverted yield curve and how it might be indicating bleak economic times ahead. But many investors don’t understand what the yield curve is or how it can indicate future economic difficulties. On this episode, I explain what the yield curve is, discuss how predictive it is of recession, and explain why we should not be too quick to take the yield curve alone as a sign of bad things to come. I hope you’ll take the time to listen.
Outline of This Episode
- [0:41] An inverted yield curve and why it’s important
- [1:30] An illustration that explains what happens with an inverted yield curve
- [4:31] How predictive is the yield curve?
- [6:08] Why you need to keep in mind that this is only one indicator
- [7:20] Recap of the yield curve and its importance
Explaining the inverted yield curve in simple terms
We’ve all seen financial charts, with lines moving up and down over time. When you hear people talking about the inverted yield curve, they are referring to one of these charts, the one that reflects the US Treasury bond market. The lines on the chart show the interest rates of Treasury Bonds across the maturity date spectrum.
A normal yield curve is an upward sloping line, which means that investors have a healthy risk appetite (are willing to invest in higher-risk investment classes). It means that investors will receive lower rates when investing in shorter-term Treasury Bonds and higher rates for investing in longer maturities.
When the line on the chart begins to flatten – meaning interest rates are becoming greater for shorter maturity periods, it’s not a good sign. It means confidence in the economic health of the country is becoming pessimistic – to the point that the sloping line can head downward. This is the inverted yield curve we’re talking about. Listen to learn what this inversion means for the economy as a whole and why it could mean a recession is in the near future.
The problems that arise when the yield curve inverts
When you first hear of the inverted yield curve it may simply sound like numbers on a chart. Why does it represent such a problem? Remember that those numbers represent real conditions in the Treasury Bond Market that indicate that real-life investors are hesitant to put their money into securities that are considered riskier. Some of those investors are banks.
Why are we concerned about banks? Because the way banks make money, on a very basic level, is to use the money their customers have on deposit to invest in other things – usually the same kind of things the typical investor is putting her money in. So if typical investors are afraid to risk money in vehicles other than Treasury Bonds, the banks will be too. That means banks have less opportunity to make money (what they are in business to do). This causes liquidity to dry up in the financial sector, which negatively impacts the liquidity of funds in all other sectors.
How predictive IS an inverted yield curve?
While it’s true that there are many other financial indicators we should consider when trying to forecast the possibility of a recession, the yield curve is what I consider to be the biggest indicator. Since 1955 a recession has always occurred within 2 years of an inverted yield curve, with only one exception in 1967. In that case, many factors contributed to the “false positive” indication the inverted yield curve indicated.
As you can see, the yield curve is a pretty reliable predictor of financial health and possible recession. But I want to make a disclaimer here – in a very low-interest-rate environment like we’re experiencing now, the inverted yield curve we’re experiencing could be another false positive because we’ve never seen it happen in this kind of economic situation. That means we don’t know what it indicates under these conditions.
Short-term good news typical of an inverted yield curve
While the inversion of the yield curve could be predicting bleak economic times in the near future there is good news on the short-term horizon. Impressive gains typically occur in the 12 months between the inversion and the recession, with an average return of 12%. Of course, there is no guarantee this will continue to happen – even in the presence of the inversion.
I hope you find my explanation of the inverted yield curve helpful as you consider the financial options available to you. Please keep in mind, none of my explanation is to be construed as financial advice but is for informational purposes only.
Connect With Ryan A. Hughes and Bull Oak Capital
- Podcast (at) BullOakCapital.com
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