Yield Curve – Misunderstandings, Fears & Opportunity

Who wouldn’t want to see a road sign which points you in a direction of where the economy, interest rates and the markets are heading? Some may even prefer a crystal ball, others will attempt to be a bit more analytical in their approach by looking at a graph of the Treasury yield curve. The bond market can be a great predictor of future economic activity and future levels of inflation – which can affect the price of everything from stocks and real estate to household items. Bond yields and interest rates are highly correlated and many will use these terms interchangeably

Recently, you may have heard media commentators warning of an impending recession as a result of a recent inverted yield curve. What does this curve really tell us and what are the implications for investors?

Watch Your Curves

The “yield curve” plots the yields of Treasuries versus key maturities. The graph typically spans short, intermediate, and longer maturities with their corresponding Treasury yields.

A “normal” yield curve shows rising yields as the duration increases – the graph slopes upward from left to right. This is generally associated with a period of less risk and investors are rewarded for investing in longer duration investments. The economy is expected to grow at a normal pace without significant change to inflation. When this curve deviates from this pattern, it could indicate potential turning points in the economy. A normal curve has yields on 30-year Treasury bonds typically 2.3 percentage points higher than the yield on 3-month Treasury bills.

When the steepness of the slope increases, long-term bond investors are sending a message to investors of what they think of the direction of economic growth and inflation. A steep curve is generally found at the beginning of a period of economic expansion. At this point, previous economic stagnation would have depressed short-term interest rates which were likely lowered by the Fed as a way to stimulate the economy. But as the economy begins to expand, one of the first signs is an increased demand for capital, which can lead to inflation. Long-term bond investors fear being locked into low rates, which could erode future buying power if inflation sets in. As a result, they demand greater compensation – in the form of higher rates – for their long-term commitment.

An “inverted” curve often occurs in a scenario with slower economic growth or even stagnation. In order for an inverted curve to exist, the short and long-term rates must move towards one another creating what would appear to be a flat “curve.”

On Dec. 3, 2018, the yield curve actually dipped its toes in and inverted, with a yield of 2.83% on the 5-year Treasury note falling to 1 basis point lower than the yield of 2.84% on the 3-year Treasury note. Among several other factors, this probably contributed to the Dow Jones industrial average’s 795 point fall that day.

Fear the Curve?

Impending recession? Should investors make changes to their asset allocation or security selection? Historically, approximately 16-months1 (on average) after a flat Treasury yield curve has occurred, a recession follows. Like any average, the yield curve is not a soothsayer telling the exact time of when a recession will occur – is it imminent or will it occur later? Being early or late in your prediction based on the yield curve still means you are wrong in both cases. There can be many other factors that affect the timing of a recession. The curve typically flattens during Federal Reserve hiking cycles – a cycle that should look very familiar to most investors today. Afterwards, there is typically a 12-month economic setback when the economy struggles to right itself.

The next logical question that many investors will ask is what effect the inversion will have on stock market performance.

Keep Calm and Carry On

Market analysts have shown that equity returns were a “mixed bag” (as measured by MSCI local currency indices)2. Higher equity returns occurred in the US index approximately 66% of the time at the 12-month mark and only 33% of the time 36 months later. When international equities are also included, returns of the indices were higher 86% of the time 12 months later and 71% of the time 36 months later respectively.

It has been concluded that an inverted curve may be a reliable indicator that a recession is likely to begin within approximately 2 years, but the resulting stock market performance may be more difficult to predict.

This should throw some restraint onto those who are tempted to quickly react to the calls from the media of an impending recession.

1 Swedroe, Larry, Don’t Fear the Yield Curve Inversion, http://advisorperspective.com, January, 22, 2019.
2 Crill, Wes, and Dimensional Fund Advisors, What Does a Yield Curve Inversion Mean For Investors?, August, 2018.

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