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For The First Time In 12 Years, The Yield Curve Inverted! What Does This Mean For Recessions?

For The First Time In 12 Years, The Yield Curve Inverted! What Does This Mean For Recessions?

It’s been another volatile week in the stock market. The big worry this week is that the “yield curve” inverted for the first time in 12 years. But what does that mean and why do people think that’s significant? Let’s have a look.

Yield Curve, Defined

The yield curve is a plot of U.S. Government bond rates for bonds that mature in different years. There are bonds that mature in a month, a year, 5 years, 10 years, and so on. Investors like to plot these on a graph to compare how different bonds have different yields, as seen here.

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Looking at the Current Yield Curve (as of 8/14/19) you can see that a bond maturing in one month yields about 2.0% right now. A bond maturing in 1 year currently yields about 1.75% and then looking all the way to the right, you can see that a bond maturing in 30 years yields a bit more than 2.0%.

Normal & Inverted Yield Curves

A “normal” yield curve will always slope upwards and to the right. You can see in the graph above that a year ago, the yield curve was indeed normal. 1-month rates were at 2.0% while 30 years rates were just above 3.0%. 

The reason why normal yield curves look like this is because investors demand extra compensation for holding a bond that matures in the future. If you own a 1-month bond, you can be pretty sure that you’re going to get your money back. But if you own a 30-year bond, there’s a lot of time for things to go wrong, so you want to be compensated for that risk. Another reason why it slopes upward is because investors are generally optimistic. They expect good times to last and for interest rates to increase as a result.

An “inverted” yield curve, on the other hand, tends to slope downwards and to the right. The same rules apply about investors demanding extra compensation for bonds that mature many years into the future. But in this case, investors are downbeat on future economic activity and expect rates to go lower in the future as the Federal Reserve cuts rates in order to help the economy.

Inverted Yield Curves May Signal Recession

A popular way to look at yield curve steepness or inversion is to compare 10-year and 2-year yields. If 10-year yields are lower than 2-year yields, many investors take that as a sign that a recession is coming. A full 40-year history of this yield curve is here.

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The shaded areas are past recessions. And what you quickly notice is that before every recession since the late 70’s, the yield curve inverted (i.e. the 10-year yield minus the 2-year yield was below zero). There’s usually a delay between the yield curve inverting and the onset of the recession.

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So is a Recession Coming?

Given the history of an inverted yield curve signaling a future recession, it’s natural to worry that the current inversion is a sign that the economy will weaken. As Mark Twain is attributed to have said, “History doesn’t repeat itself but it often rhymes.” We should certainly respect history, but keep in mind that the current situation is different from those previous episodes.

The biggest factor that’s different today is that central banks in Europe and Japan are actively distorting their bond markets by driving interest rates to zero. In fact, many government bonds in these countries have yields that are below zero, as crazy as that sounds. 

As global investors are faced with negative yields on government bonds in their home markets, they look overseas for a better deal. And right now, the U.S. is the “best deal in town” in terms of having some of the highest bond yields in the developed world. This overseas buying is forcing U.S. yields to decline (higher prices = lower yields). 

Hence, one can argue that the extremely low interest rates seen here in the U.S. are due more to external, overseas factors than investors taking a position that a recession is on the horizon. Only time will tell whether this week’s inversion is a sign of an impending recession. Regardless of what happens, we’re always managing client portfolios to achieve client goals, taking advantage of the ups and downs of the market to reposition investments as needed in a volatile, unpredictable world.

Wondering how this affects your investments? Schedule a call with Michelle and Steve to discuss your portfolio today.

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