The Dreaded Inverted Yield Curve

Who's afraid of the big bad bond market standing on its head? Not the chief of the New York Fed, who says an inverted yield curve is not worth running from.

DOW Stocks

On Sept. 6, New York Federal Reserve President John Williams boldly said that the Fed shouldn’t hesitate to invert the yield curve.

If the news reached you at all and you are not an investment professional, there’s a more than even chance that your reaction was something like: “What’s a yield curve and why should I care if the Fed inverts it?”

Yields are usually higher for long-term bonds than short-term bonds of equal credit quality. This is because investors are taking on more risk with a longer time horizon. It feels relatively safe to guess how well a government or a bank will be functioning in a year or two, but it becomes much riskier when you measure in decades.

Generally speaking, you can graph the relationship between bond yields and their maturity dates; the result is what economists mean when they describe a yield curve. That’s because the most common result of such a graph is a rising curve that levels out at the top. The yield curve that economists usually focus on is the one measuring the yields versus maturities of certain U.S. Treasury bonds.

Sometimes economic conditions exert enough pressure to change the shape of this graph. As short-term interest rates rise, for instance, increasingly similar yields between short- and long-term bonds can lead to a “flat” yield curve. Bloomberg recently reported that, in the past six months, 10-year Treasury note yields have fluctuated around 2.9 percent, but two-year notes’ yield has risen 0.4 percent, narrowing the difference between their yields to the smallest amount since 2007. By this measure, we are solidly in flat yield curve territory.

If short-term bond yields actually surpass long-term bond yields, the inverted yield curve arises.

Historically, an inverted yield curve has signaled an oncoming recession, because it indicates that investors are deeply worried about the future. While long-term Treasury bonds are riskier than short-term Treasuries, they are still relatively safe investments. If investors anticipate that interest rates are likely to trend downward, they will try to lock in better long-term rates as soon as possible. As a greater number of nervous investors pile into long-term bonds, the yield tends to decrease due to basic supply and demand.

Inverted yield curves have preceded every U.S. recession since the 1960s. While inverted yield curves don’t cause recessions outright, they are often among the first symptoms that one is on the way. And while a flat yield curve is not a problem in itself, it does mean that it would not take much change to tip into an inversion, which is why it worries some economists and investors.

The yield curve is currently flat, in part, because the Federal Reserve exerts greater control over short-term yields than long-term yields. The Fed sets the federal funds rate, which governs short-term borrowing; it has slowly but deliberately raised this rate for the past few years and is committed to continuing in an effort to return to historically normal interest rates. But even as the Fed raises short-term rates, long-term rates haven’t significantly budged. This has caused some economists to raise the alarm, including several regional Fed presidents who have said the central bank should take concrete steps to make sure the yield curve does not invert. Fed Chairman Jerome Powell has said the yield curve is important to watch, though in his view it does not yet indicate any recession danger.

If all of this is true, why would the president of the New York Fed urge his fellow central bankers to keep raising interest rates, even if it could cause an inverted yield curve? Williams’ point was that the Fed needs to consider the state of the economy as a whole when deciding to raise rates, rather than letting fear of an inverted yield curve prevent action. Part of his reasoning is that the global economic picture looks different today than it did in the past. For example, the Fed and other central banks have bought many long-term assets outright, which has arguably pushed down yields on long-term Treasuries artificially. And while the Fed has unwound some of its post-crisis quantitative easing, many other major world economies like Japan and the European Union are still engaged in it, which makes American Treasuries attractive by comparison, even if their yield is low in absolute terms. China alone holds almost $1.2 trillion in U.S. Treasuries.

Williams also noted that between low unemployment and low inflation, “this is about as good as it gets” economically speaking. An inverted yield curve would not immediately undo all the other economic strength the United States currently enjoys. And depressed wage growth for the past few years means, at least in Williams’ view, that the economy still has room to expand.

Treasury Secretary Steve Mnuchin, too, has said that he is not worried by the prospect of an inverted yield curve. In late August, he told CNBC, “I think [the yield curve is] a market condition, and for now having a flat yield curve with us issuing long-term debt is something we’re perfectly content with.”

As I have written before, recessions are a normal part of the economic cycle. But an inverted yield curve is not a curse that will magically turn clear economic skies stormy, either.

If an inverted yield curve arrives, investors should bear a few things in mind. First, don’t panic. An inverted yield curve correlates with the potential for a recession, but as every beginning statistics student can tell you, correlation does not equal causation. Otherwise, we would have to seriously look into whether people were getting divorced in Maine because Americans were eating too much margarine.

That said, the connection between an inverted yield curve and a recession is not entirely spurious. An inverted yield curve can affect the probability of a recession to a degree, in that it poses the risk of a self-fulfilling prophecy. Investors who see an inverted yield curve as a surefire recession signal may change their behavior accordingly. As demand shifts, bond yields will move in response.

Perhaps more importantly, an inverted yield curve can make banks more reluctant to lend. Banks borrow at short-term rates and lend at long-term rates; the difference is usually where they make their profit. If they can’t earn a reasonable return on mortgages or other long-term loans, banks will be reluctant to lend freely, especially to riskier borrowers. And when banks are less willing to lend, small and medium businesses may end up delaying or canceling plans to expand because they lose access to credit. This can push the economy toward recession.

However, if the economy is otherwise healthy, the Federal Reserve raising short-term interest rates far enough to invert the yield curve will not instantly and automatically trigger a recession. The bond market is only one element of a much larger picture.

Even if an inverted yield curve does signal a recession, it is not a reliable indicator of its timing. As Aaron Anderson, senior vice president and head of research at Fisher Investments, pointed out in a column for The Street, historically the economy can grow for many months after an inversion begins. The time from an inversion to a recession can stretch as far as a couple of years, as it did prior to the most recent recession. The yield curve inverted in January 2006, and stocks didn’t begin their descent until 2008.

Investors should not, however, simply ignore an inverted yield curve. At the very least, they should calmly and thoughtfully evaluate their portfolio’s bond allocation in light of the upside-down circumstances an inverted yield curve indicates. You may or may not want to make a change, but it is worth at least asking why you should hold on to your long-term bonds in an environment where short-term alternatives offer both lower risk and higher yield.

An inverted yield curve is a strange and rare phenomenon. Even when it arrives, it does not usually last very long. Regardless of what it may or may not tell us about the economy’s near future, an inverted yield curve is a good signal for investors to make sure their basic financial plan is sound and that they are prepared to keep their focus firmly on the long term.

About Paul Jacobs 8 Articles

Affiliation: Palisades Hudson Financial Group

Paul Jacobs, CFP®, EA, joined Palisades Hudson as an associate in Scarsdale in 2002. In 2006 he became a client service manager and transferred to Fort Lauderdale. In 2008 Paul moved to Atlanta, where he is presently the client service manager in charge, to establish the firm’s office there.

As chief investment officer and chairman of the firm’s investment committee, Paul directs a team of portfolio managers and associates focused on finding the most efficient and cost-effective ways to implement client portfolio strategies. He oversees more than $1 billion in client assets, including all aspects of investment strategy, portfolio management, due diligence, and manager selection.

Paul formerly served as the firm’s Chief Compliance Officer, and he has had extensive experience in the firm’s investment management and tax compliance practices. His additional responsibilities include developing and monitoring client portfolios, reviewing tax strategies and returns for clients, and developing comprehensive personal financial plans. He also has worked on client projects involving charitable planning, bookkeeping, retirement planning, and estate planning and administration.

Paul graduated from New York University’s Stern School of Business with degrees in finance and accounting. He is a CERTIFIED FINANCIAL PLANNER® certificant, an Enrolled Agent and a member of the Financial Planning Association of Georgia.

Paul is the author or co-author of numerous Sentinel articles, including “Pay As You Go: Tax Rules Upon Expatriation” (June 2012), “Beware Mutual Funds Using Hedge Fund Strategies” (January 2012), “Is There A Bubble In The Bond Market?” (October 2010), “Should You Do A Roth IRA Conversion?” (February 2010), and “Private Equity In A Deleveraged World” (April 2009).

Visit: Palisades Hudson

Be the first to comment

Leave a Reply

Your email address will not be published.


*