The Inverted Yield Curve – What you need to know. – OptionsANIMAL
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The Inverted Yield Curve – What you need to know.

In the last few weeks of March 2019, the headlines in financial media were consumed by the news of the inverted yield curve.

What does an inverted yield curve mean? The U.S. Treasury issues bonds for different periods of time, e.g., 3 month, 6 month, 1 year, 10 year, etc.. The price of the bond and interest rates paid, a.k.a., the yield, are set by auction. Normally, investors are rewarded with a higher rate for longer-term investments. The inverted yield curve means that investors are getting better returns on short-term treasuries than long-term.

Why is this a big deal? Because it doesn’t happen very often and in the past, it has been the harbinger of a recession. In the case of the 10-year versus the 3-month for the past 36 years, the yield on the 10-year has been higher than the 3-month 95% of the time. And every modern recession has been preceded by an inverted yield curve.

What’s a recession? It is a contraction in economic activity. It’s defined by two consecutive quarters of negative GDP growth. The consequences associated with a recession are rising unemployment and a falling stock market.

Why did the yield curve invert? Economists will write their Ph.D. dissertations on this topic. The simple answer is that the yield curve inverted because that is what the market has dictated. The yield curve normally slopes upward. Part of the reason for the inversion is that the front part of the curve (shorter-term Treasury yields) is rising faster than the back part of the curve (longer-term Treasury yields) due to the increase in the Fed Funds Rate.

What’s the Fed Funds Rate? It’s the rate at which the Federal Reserve (https://www.federalreserve.gov/) loans money to various depository institutions, like banks and credit unions. The Federal Reserve and U.S. Treasury are separate entities and the Fed does not directly set the Treasury rates. But short-term Treasuries are always just a little higher than the Fed Funds Rate. So, as the Fed has raised rates, we’ve seen the short-term Treasuries also increase. The longer-term rates are set by market dynamics. Why haven’t the longer-term yields risen? Is the trillion dollar question.

Does the inverted yield mean there is a recession coming? Howard Marks of Oaktree Capital (https://www.oaktreecapital.com/insights/howard-marks-memos) points out in his recent book Mastering the Market Cycle: Getting the Odds on Your Side (https://www.masteringthemarketcycle.com/), the market is in a continuous cycle. It is not a matter of “if” a recession will occur. It’s a matter of when the next recession will occur. Like winter in HBO’s Game of Thrones (https://www.hbo.com/game-of-thrones/), we never know when the next recession comes – but we know winter is coming.

Does the inverted yield predict or cause a recession? It’s probably a little bit of both. Economist have many theories. But rising interest rates and inflation are generally bad for business and ultimately hit company earnings, which lowers the valuations of companies, and ultimately causes stock prices to fall. This changes the risk dynamic and investors who are looking to protect themselves will seek low-risk places to invest. Some investors will decide to move money from the stock market to short-term Treasuries – where they get a known return and essentially no risk.

Is it different this time? There are a lot of things that are different. The rates in the yield curve are lower than previous yield curve inversions. The Federal Reserve has just come off the longest quantitative easing program in history. The current Fed has acknowledged that its likely done raising rates for the rest of 2019 and may even lower them. The current administration has shown great interest in trying to keep the economy and the stock market healthy. In This Time Is Different: Eight Centuries of Financial Folly by Reinhart and Rogoff (http://www.reinhartandrogoff.com/), the authors point out that for over 800 years, each economic crisis was different. However, the thing that was common for all of them was that there were experts – economists, central bankers, policymakers, and investors – who were confident that “this time it is different” and it wasn’t. Perhaps it’s human nature to want to keep markets calm. And maybe somehow, acknowledging the crisis makes it come. Whatever the reasons, you can be assured that there will be experts telling you to Keep Calm and Carry On as we fall into a recession – like the British did in 1939 to downplay the threat of the German air attacks.

https://en.wikipedia.org/wiki/Keep_Calm_and_Carry_On#/media/File:Keep-calm-and-carry-on-scan.jpg

Who do we listen to then? There really are not many experts who have practical firsthand experience with recessions. An expert who has 36 years of experience has only seen three recessions. Some economists have spent their careers studying past recessions. But even exalted economist have gotten them wrong in the past. It’s probably best if you be the judge of things.

How will we know when there is a recession? Unfortunately, we won’t officially know until we are well into it. The date of the recession is back-dated after we have two quarters with negative GDP growth. In the past, the beginning of the recession occurs between one and three years after the yield curve inversion. But there will be signs as we get closer and deeper into a recession. A broad indicator of economic health is the Conference Board’s Leading Economic Index (LEI) (https://www.conference-board.org/data/bcicountry.cfm?cid=1). The LEI tends to rollover before a recession. Note that the LEI can rollover without a recession occurring, but when it happens in coincidence with an inverted yield curve there has always been a recession following. We will see changes in other economic indicators such as rising unemployment, weakening industrial output, falling consumer confidence, and extreme dollar valuations relative to other currencies. We will also see the yield curve will revert to a normal curve. And that will cause some experts to declare that the crisis was averted.

What should I do about this? You should seek advice from a registered professional advisor before you make any decisions. But history has shown that those investors who kept level heads through past recessions did well if they did nothing and kept their investments in the market. The market has recovered very nicely since the Great Recession of 2008. However, if your time horizon for needing that retirement money is shorter than a decade, it may be prudent to seek ways to protect those assets now. Be aware that, like the crew of the Titanic – told people to remain calm, as the band played on – some experts will give you that same advice. You probably shouldn’t be heading for your lifeboat just yet, but you should know where your lifeboat is and have a plan to get to it when you need it.

https://en.wikipedia.org/wiki/RMS_Titanic#/media/File:RMS_Titanic_3.jpg

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Eric Hale

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