Yield Curve Inversion

Yesterday, the Dow, Nasdaq and S&P 500 all dropped around 3%. Important to keep perspective that the S&P 500 is still positive by roughly 15% year to date. 

So, what’s causing the concern?

The U.S. Treasury yield curve inverted on Wednesday for the first time since June 2007, in a sign of investor concern that the world’s biggest economy could be heading for recession. The inversion – where shorter-dated borrowing costs are higher than longer ones – saw U.S. 2-year note yields rise above the 10-year yield. 

Weak economic data and low inflation around the world, global trade conflicts and political tensions in places such as Hong Kong have sparked worries about world growth, fueling market expectations of central bank interest rate cuts and triggering steep falls in government bond yields.

The U.S. curve inverted on Wednesday to as much as minus 2.1 basis points US2US10=TWEB, a metric widely viewed as a classic recession signal. The last time this yield curve inverted was in June 2007 when the U.S. subprime mortgage crisis was gathering pace.

The U.S. curve has inverted before every recession in the past 50 years, offering a false signal just once in that time. (Reuters)

Historically, what’s happened after an inversion?

“Stocks typically have 18 months of gains following inversion of the 2-10 spread until returns start to turn negative, Credit Suisse data showed. The market rallies more than 15% on average in the 18 months following the inversion. A recession hits in 22 months after the inversion, according to Credit Suisse.” (CNBC)

Averages can be comforting, but keep in mind the actual figures are fairly sporadic. There aren’t any rules or requirements for when these events take place. 

An inversion is considered a big deal because it means people were allowing the government to borrow money for 10 years at a lower rate than they were allowing them to borrow for 2 years. Counter intuitive right? 

Naturally, you may ask, why would anyone do that?

There are a number of reasons investors and economists point to. One of the most cited reasons tends to be that investors who are pessimistic about the outlook for the economy choose the safety of long-term government bonds to avoid the potential losses that would come from a recession. Basically, they want to be certain over ten years they are getting something positive, rather than risk losing money. This increased demand for safety drives down the interest rate for ten year bonds below the rate for two year bonds. 

Perhaps a wrinkle?

Former Federal Reserve Chair, Janet Yellen, argues market expectations might not be clear this time around. Unlike past inversion occurrences, there are a number of “non-market forces” influencing the yield curve today. Yellen said on Fox Business Network,

Historically, it has been a pretty good signal of recession, and I think that’s why markets pay attention to it, but I would really urge that on this occasion it may be a less good signal and the reason for that is there are a number of factors other than market expectations about the future path of interest rates that are pushing down long-term yields.

What does this mean for my portfolio and my business? 

I’ve said this a number of times before, but a proper plan should account for up, down and sideways markets with an emphasis on controlling what is actually within your control. I take pride knowing the business and personal finance members I work with have comfortably established, or are in the process of establishing, their emergency fund for this exact type of reason. 

Does a yield curve inversion mean a recession is coming?

To be snarky, at SOME point, it is inevitable. I think it should be difficult for anyone to provide a convincing answer about what this inversion means in particular though. Unfortunately, “I don’t know” is often the best, but least used response in finance. There are still a number of solid economic data points and the economy doesn’t work like a math problem. There is nothing that says if X happens, Y will occur. It is more like a complex biology system with a number of interacting factors. The inversion happening before 9 of the last 9 recessions is intimidating, but there are WAY more people paying attention to this metric now then there were during the prior occurrences. Maybe all this attention changes its usefulness as a predictor? This has happened before with other popular market monitoring techniques.

There is a chance the inversion means nothing, and a chance it means something. Those of you with a proper plan will be fine either way. Our job is to make sure you’re on track to meet your personal goals even after accounting for the eventual downturns in the market, whenever they may come. If your plan is to take action only after a downturn has already taken place, well at that point you’re already too late. Don’t wait to develop a strategy.