Yield Curve Inversion-What is It?

Yield Curve Inversion-What is It?

2019-09-05T10:00:48-04:00August 27, 2019|

I was speaking with a a financial planning client last week on the subject of refinancing her mortgage.  I offhandedly said something to the effect that “the yield curve inversion might lead to a good opportunity to lock in a lower rate” (more on this later).  She didn’t really say anything and it became clear that she didn’t really get what I was saying.  She had heard it discussed on TV, seen posts about it on social media, etc. but didn’t really know what it meant or, more importantly, why it mattered.

Inversion

Typically interest rate yields (often Treasuries are cited) rise the longer one is until maturity.  Makes sense.  An investor should expect more yield the longer their money is locked up in a bond.  So a 10 year bond might yield roughly 2.8% as it did one year ago (August 23, 2018) while the 2 year bond yields ~2.6% as it did one year ago.  In fact, the spread between those two bonds is often cited as a sign of the strength of the economy.  The previous example is considered a rising yield curve.

An inversion is the exact opposite.  The yield on a 10 year Treasury is LESS than the yield on a 2 year Treasury.  This is fairly rare.  As of this writing both are almost exactly 1.525%.  The yield curve did invert this month and, in fact, a 30 day Treasury is currently yielding ~2%.

So What?

Good question.  I suppose it could be debated what this actually means.  However, what it has meant historically is that the inversion has led to a near term recession.  Based on the chart below, 7 of the last 7 yield inversions have led to recessions.

This doesn’t mean the recessions started immediately after the inversion.  No, generally recessions have occurred 12-18 months AFTER the inversion.  So if the playbook stays true to it’s history, a recession is likely in August 2020-February 2021.  Time will tell on that.  But the point remains that this is a sign that there is a high correlation between inversions and recessions.  To be sure, the sample size isn’t huge but to date the correlation has been evident in all of the last 7 examples.

Why? 

Nice chart Brian but WTH does this mean.  Well obviously it means that investors are more comfortable locking up their money for a long period of time (say 10 years) then they are for 2 years.  The market is pricing in an expectation of a recession by buying down the yield on the longer term bond.  That is unusual.  But that is just a supply/demand lesson.  More buyers (demand) leads to higher prices (supply).  In a bond market, higher prices to purchase intuitively means less yield.

But that doesn’t answer why it happened.  As always, I’m reluctant to pin specific absolute reasons for this occurrence.  However, I do think the market is sending a signal that the US/China trade war will have a greater impact on the economy going forward.  I suspect the markets are also expecting uncertainty related to the 2020 elections…which just so happens to fall in the window for expected recession.  Might this lead to attempts by the current administration to stave off a signaled recession?  Might some of the administrative proposals contain political components that are unappealing to the markets?  All questions that only time will tell.

What to do?

  • Number one is to make sure your investments are properly diversified (ie balanced).  Diversification is important regardless of your portfolio make up.  A bond portfolio needs to be diversified across credit quality, length to maturity, etc.  A stock portfolio needs to be diversified across size of the issuing company, industry types and home country of the company.  Although the global economy has become smaller and smaller there is still a lot of value in diversifying across borders and amongst developed and emerging markets.
  • Make certain you have adequate cash savings as a buffer should you need it.  A common rule of thumb is to have at least 4-6 months of liquid cash available.  If your monthly expenses are, for example, $5,000 it makes sense to have somewhere around $30,000 available for emergencies.
  • Take a look at your mortgage(s).  For some taxpayers the tax advantages of mortgages has been minimized.  Also, rates have dropped significantly over the last 12 months or so.  Don’t be afraid to lock up mortgages for longer periods of time.  You can always pay down mortgages faster if cash flow allows it.
  • On that note, look at all of your debts and try to pay off as much as possible.  Credit often becomes tightened (harder to access) in recessions.  Not having to worry about paying down unnecessary debt can be a life-saver in tough times.

Time will tell what the impact is of this yield curve inversion.  The market is clearly beginning to price in an expectation of a stagnating economy.  That may result in people losing jobs, stock market sluggishness or a multitude of other unexpected financial concerns.

Please don’t hesitate to reach out to us if you are thinking about this and wish to discuss further.  There is a lot of financial noise available if you allow yourself to hear it.  Our goal is to help clients decipher the important noise and act in a sensible long term way.