The Inverted Yield Curve: What is it and What Does it Mean for Our Economy?
You may recently have heard some chatter, panic and discussion about the inverted yield curve in financial circles. Is it something you should be worried about? What does it mean for your investments and the larger economy as a whole?
So, What is the Yield Curve?
People often talk about interest rates as though all rates behave in the same way. The reality, is much more complex. A yield curve is a way to easily visualize this difference between long and short maturing bonds. Basically the relation between the costs of borrowing against the “term” of the loan.
What is So Special About the Yield Curve?
Well, the curve is used to measure bond investors’ feelings about risk and also to make some fairly successful predictions on future economic strength. When shorter term treasury bonds have a higher yield than their long-term counterparts – the yield curve turns negative. And it’s this change that has some investors and financial planners worried.
What Does a Negative or Inverted Yield Curve Mean?
A negative yield curve is viewed as one of the most reliable recession indicators. And though it can take between up to 34 months for a recession to hit after the curve turns upside-down, it’s among the first signs an economy is shrinking. We have a lot of evidence to back up this prediction. Every recession in the US since 1950 has been preceded by an inverse yield curve. Some recent examples include the 2007 recession, the global financial crisis and the 2001 tech bubble burst.
How does this happen? Well, when long-term bonds – traditionally those with higher yields – see their returns fall below those of short-term bonds – it creates this black hole in supply and demand. Savvy investors flock to long-term bonds when they see the economy falling in the near future. This increased demand drives long-term bond prices higher, and pushes yields lower accordingly. The higher the initial price of the bond, the less profit one makes when it reaches maturity. This of course, causes the opposite in short term bonds – investors fearing an upcoming economic downturn demand less short-term bonds – which drives prices lower. Lower prices bring higher yields.
Essentially, inverted yield curves arrive when long-term debt is deemed riskier than short term debt. Though many investors try – and fail – to time the exact moment to buy or sell assets to maximise their returns, the consensus represented by an inversion is historically correct, and foreshadows economic woes to come.
What Does Our Yield Curve Look Like Right Now?
August was a month of extreme angst, concern and panic amongst investors. Yields on two-year bonds began to outperform ten-year bonds and the yield curve inverted by 1.86% – the biggest spread since the recession of 2007. This is partly due to many investors abandoning the stock market in response to concerns about a global economic slowdown being exacerbated by the U.S.-China trade war. It doesn’t seem to be improving either, with yields on 30-year Treasury bonds sinking to an all-time low record of 1.91% on the 27th of August.
Are We Definitely Headed for a Recession?
It is true that every recession has been preceded by an inverted yield curve. But not every inverted yield curve has prompted a recession – there are other factors that come into play. In 1995 and 1998 after the yield curve became inverted the Federal Reserve cut short term rates to restore an upward slope. There was no recession. Actually, according to a Credit Suisse report, on average, markets rally about 15% after a yield curve inversion takes place.
If the Federal Reserve or other central banks believe the economy is overheating with a threat of inflation building, they will raise short term rates to head that off. Generally, they will telegraph their intention to engineer a “soft landing” and slow the economic expansion. The investor fear is that the Federal Reserve will overreact and raise rates too early and/or too much thus triggering a recession. In turn this promotes a herd mentality that further moves markets.
Longer term rates are much more market driven. However, even here central banks can massively intervene to influence interest rates or manipulate their currencies.
Should We Panic Anyway?
Ultimately, no recession is the same, and there’s no guarantee that the next downturn will cause any kind of financial loss. Economists look at countless metrics to predict what future recessions will look like, including: the unemployment rate, home starts, wage growth, consumer confidence, GDP, job quits, and consumer debt. Keeping an eye on a select number of popular metrics can help investors weather the storm if a recession grows increasingly likely.
September has a notoriously difficult reputation when it comes to stock market performance – this will weigh on financial investors’ minds as they keep one eye on the yield curve. But experts warn that there is no need to withdraw and bury your life saving just yet. For one – recession symptoms generally appear 2 years after the yield curve inverts. Secondly, other economic indicators are optimistic. The GDP – the broadest gauge of economic activity, grew at a moderate 2% annual rate in the April-June quarter. That’s down from a 3.1% gain in the first quarter.
Another encouraging sign is that consumer spending, which drives about 70% of growth, accelerated last quarter at the fastest pace in nearly five years. At the same time, business investment, which has weakened in the face of President Donald Trump’s trade wars, was revised lower and subtracted from growth in the April-June period.
Chartered Retirement Planning Counselor (CRPC) conferred by College for Financial Planning.
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