The Drama of the Inverted Yield Curve
This past weekend’s news channels were consumed with President Trump, Robert Mueller, and the report summary of the Russia collusion investigation. If you were paying attention to the economic news before this took over the media, you likely heard the alarmist headlines on Friday about the inverted yield curve, which (you probably also read) inevitably signals an upcoming economic recession. Hopefully, it doesn’t have you upset and thinking about retreating to the sidelines until the claimed economic bust is over.
If you follow this instinct you could miss out on some gains you need for your long-term plan! Read on to discover this has been an unreliable predictor of recession and what it does predict, when right, is many months later.
The S&P 500, on Friday, dropped 1.9%, as people reacted as if a recession would happen on Monday. Investing would be easy if it were that simple. But in the current case, it is more complicated than the articles may lead you to believe.
The yield curve is a line plotting out the interest rate (yield) that is paid to investors across maturities, from three months to 30 years. An inversion happens whenever a shorter maturity bond provides higher yields a longer-term one—which is counterintuitive since the risks of holding bonds longer-term are greater than if you’re parking your money for a few months. Longer-term, you could experience inflation, default or a rise in interest rates that will make you look stupid for committing your money at a particular rate for ten years or longer.
This current so-called “yield curve inversion” really looks more like a flat line stretching from short-term to intermediate-term bonds. What was widely reported was a (probably brief) moment when the 3-month Treasury note offered higher interest than the 10-year bond—by (get ready to be shocked) 0.022%. You could see roughly the same spread difference around the beginning of 2006, which was not a very clear signal and we did not experience a recession until a year and a half later. Some months afterward, what we would say was the actual signal the yield curve inverted with a vengeance, although it righted itself before the worst carnage of 2008.
The lesson here is that, yes, we have experienced a yield curve inversion sometime before each of the last seven recessions. However, there have also been two false positives—an inversion in late 1966 that was followed by economic growth, and a largely flat curve, like the one we are experiencing now, in late 1998 that also didn’t presage a recession.
Even if we accept the idea that a yield curve is a recession signal, the actual timing is almost impossible to predict. Data from Bianco Research has shown that over the last 50 years, a recession followed, on average, 311 days later—roughly a year. Based on this evidence, selling the day after an inversion seems like a poor strategy. Selling a month, or six months after doesn’t make sense either.
Finally, some economists think that the yield curve is not nearly the accurate signal that it once was. The reasons are a bit technical, but they have to do with the increasing control that the central banks—including the U.S. Fed—have on the shorter end of the yield curve. The Fed and other central banks have been buying up government bonds for their balance sheet, which means the shorter-term yields can no longer be seen as market driven.
So what historically causes the yield curve to invert and are there more accurate signals of looming recession tied to them?
Yes, an overheating rate of GDP growth (which we haven’t seen at all in this long, slow recovery), rising unemployment (nope) and spiking interest rates (no sign yet). Another sign that directly impacts the yield curve is a sudden demand for longer-term bonds as a safe haven for nervous investors, causing the bond rates to drop below shorter-term paper. There has been no indication of a shift in demand for bonds over stocks.
So what does all that mean? The simple lesson is: don’t fall for clickbait. We are still as much in the dark about what the economy and markets will do in the future as we were before 3-month Treasury bills returned a shocking 0.022% more than 10-year Treasury bonds. We might experience a recession this year, or next, or in 2022. All we know for sure is that we WILL experience one, possibly with a few unexpected market ups and downs in the meantime.
What we do know is your investing success is increased by staying invested throughout the market cycles in a well-diversified portfolio with a risk profile that is appropriate for your investment horizon. Keep the course and remember mass financial communications is not sufficient for making investment decisions.
Some of the information above was provided by Bob Veres Inside Information.