We Have An Inverted Yield Curve. Now What?


yield curve rocky mountain

The 10-2 year yield curve inverted on Wednesday. The S&P 500 fell nearly -3% as a result. The concern is that after a 10+ economic expansion, the US economy will slip into a recession. After all, the yield curve is one of the more reliable leading indicators.

inverted yield curve leads to recession
Source: Washington Post, St. Louis Federal Reserve

What is the Yield Curve?

The yield curve is a plotted chart that shows Treasury bond interest rates across the maturity date spectrum.

A normal yield curve will show a healthy risk appetite among investors (lower rates among shorter maturities and higher rates among longer maturities):

normal yield curve

However, the yield curve can flatten and eventually invert, meaning that shorter maturity bonds yield more than longer maturity bonds.

inverted yield curve

When this happens, it typically suggests that the long-term economic outlook is weak. As the economic cycle begins to slow, “investors see long-term yields as an acceptable substitute for the potential of lower returns in equities and other asset classes, which tend to increase bond prices and reduce yields.” (Investopedia) During these periods of forecasted economic weakness, investors flee to safe-haven assets, namely longer-term Treasury bonds. This strong demand helps push the long-term rates below shorter-term rates.

The Predictive Power of the Inverted Yield Curve

It is no secret that an inverted yield curve is associated with recessions. But just how predictive is it? And how long does it precede the start of a recession?

For those that follow our investment strategy, you know that we watch leading indicators quite a bit. In short, when leading indicators (economic factors that change before the rest of the economy moves in a particular direction) show persistent weakness, we move our portfolios to a defensive posture and vice versa.

It is important to note that there is no perfect leading indicator. But it is foolish to deny the predictive power of the yield curve. Since 1955, the spread between the 10-year and the 1-year has preceded all recessions within two years except for one false positive in 1967.

Recessions and inverted curve
Source: Federal Reserve Board of San Francisco

The economy does not typically slip into a recession immediately after an inversion. While all previous occurrences have taken place within 2 years after the inversion, a recession, on average, take place 18 months later.

This period typically provides investors with pretty impressive market gains.

return after inversion
Source: CNBC

The point is not to panic but to ensure that your portfolio is correctly allocated. The markets are largely unpredictable. Diversification and proper risk weightings are key.

Is This Time Different?

There has been speculation that this time is different. Earlier this week, Janet Yellen stated that the US economy will avoid slipping into a recession due to the inverted yield curve. She reasons that the strength of the underlying economy is strong enough to weather global weakness. Other arguments claim that because interests rates have been artificially suppressed for so long, this inverted yield curve is sending a false signal.

Moreover, is important to not discount the fact that both the White House and global Central Banks want stocks to go higher. They will likely enact policies that will support this cause.

However, we must also not igore the other risks present. We are faced with falling leading indicators, a US – Chinese trade war, anti-government Hong Kong protests, and falling corporate earnings. Europe is likely headed for a recession and the US tax cuts have already had their impact in our economy. Caution must be heeded. Now is the time to reasses your personal risk tolerance and your portfolio allocation.

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