What Investors Really Need to Know About an Inverted Yield Curve

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  • The biggest risk in the bond market isn’t rising rates or the Fed vs. Trump. It’s the inverted yield curve. At least according to the headline on CNBC.

    Over at The New York Times, it’s a similar story. “What’s the Yield Curve? ‘A Powerful Signal of Recessions’ Has Wall Street’s Attention”

    Investors are facing a flood of stories about this indicator. But, the truth is the yield curve hasn’t inverted yet. So, we can take some time to learn about what the curve is and what it means.

    The Yield Curve Shows the Price of Money

    Some analysts pay attention to the yield curve all of the time, not just when it makes the headlines. A yield curve plots a series of interest rates over time. The most frequently reported yield curve compares various maturities of U.S. Treasury debt. Curves are also available for corporate debt and other markets.

    A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter term yields are higher than the longer term yields.

    A yield curve can also be flat when the shorter and longer term yields are very close to each other.

    An example of a yield curve, base on U. S. Treasuries is shown below. It’s from December 2012 and shows a normal yield curve.

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  • yield curve

    Source: StockCharts.com

    The next chart shows a flat yield curve which occurred before the bear market of 2008.

    flat yield curve

    Source: StockCharts.com

    Finally, the next chart shows an example of an inverted yield curve which occurred as the economy was in a recession in early 2000.

    inverted yield curve

    Source: StockCharts.com

    Why The Yield Curve Is Important

    What investors are watching now is the spread between the two-year Treasury bond and a 10-year Treasury bond. This is the most popular indicator and it’s popular for a good reason. The last seven out of seven times the yield curve went negative since the 1960s, a recession followed.

    But, it’s not a precise timing tool. The yield curve can invert more than a year before a recession. The next chart, from the Federal Reserve, shows that the most recent inversion came about three years before the bear market.

    recent inversion came about three years before the bear market

    Source: Federal Reserve

    The inversion is important because it offers insights into what investors think about the economy. This insight is derived from the fact that bonds pay interest. It’s a simple fact, but like many ideas in economics, the simple facts lead to profound information.

    Typically, the 10-year pays a higher interest rate than the two-year to compensate buyers for the time difference. The difference between the interest rates in these two bonds is called the “spread.” The chart above shows this spread.

    If the spread is greater than zero, it means the two-year interest rate is lower than the 10-year, and that is normal. When the spread is negative, the yield curve inverts because short term rates are higher than long term rates. This means investors believe there is greater risk in the short term than the long term.

    When investors are more worried about the short term than the long term, we see the inversion that has been called “a powerful signal of recessions,” by the president of the New York Fed, John Williams.

    Inversions Can Be Wrong

    Now, it is important to remember that every recession of the past 60 years has been preceded by an inverted yield curve, according to research from the San Francisco Fed.

    But, while yield curve inversions have “correctly signaled all nine recessions since 1955” there has been one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession,” the bank’s researchers wrote in March.

    There is room to believe that this time could be another failed signal. According to The New York Times, the argument to be made “against reading too much into the yield curve’s moves — and it hangs on the idea that, rather than the free market, central banks have had a big influence on both the long-term and short-term rates.

    Since the last recession, central banks bought trillions of dollars of government bonds as they tried to push long-term interest rates lower in order to lend a helping hand to the economy.

    Even though they’re reversing course now, central banks still own massive amounts of those bonds, and that may be keeping long-term interest rates lower than they would otherwise be.

    Also, the Federal Reserve has been raising short-term interest rates since December 2015 and has indicated it will keep doing so this year.

    So if long-term rates were pushed lower by central bank bond buying, and now short-term rates are being pushed higher as the Fed tightens its monetary policy, the yield curve has nowhere to go but flatter.”

    “In the current environment, I think it’s a less reliable indicator than it has been in the past,” said Matthew Luzzetti, a senior economist at Deutsche Bank.”

    That’s important for investors to remember. The bull market in stocks began in March 2009 when the Federal Reserve began its aggressive easing programs and the Fed has continued to have an outsized influence in financial markets since then.

    The Fed is not alone. The Bank of Japan has been actively holding down both short and long term rates in addition to buying equities in the stock market. The European Central Bank continues to maintain an aggressive easing program.

    From a central bank perspective, this is an unusual and in many ways unprecedented time. That means we should think beyond the obvious interpretation of signals like the yield curve. This time, the curve could fail, as it did in the 1960s when the Fed was also aggressively managing long term rates.

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