The Inverted Yield Curve
To begin, let's go over what exactly the yield curve is. First, there are lots of different yield curves, but when you hear “the” yield curve, think U.S. government treasury bonds. The yield curve is simply a graph that shows the return you get for lending the government money, aka buying a US Treasury, for different time periods. Typically, the longer you lend the government money, the more compensation you should expect to receive. This is because you are parting with your money for a greater period of time and, in doing so, are taking on more risk. Now, if you plot those returns for the different time periods on a chart, you would normally see an upward slope (blue curve).
Today, we are seeing the inverse: the plotted curve starts off downward sloping (red curve). This means that if you loan the government money for three months, you make more than if you loan the money for 10 years.
If this is true, then why would anyone lend the government money for longer just to get less? The answer has to do with market sentiment and expectations. While the front or short end of the yield curve is controlled by the Fed, the long end is influenced by investors. When investors feel there is about to be an economic downturn, there is a flight-to-safety. Selling higher-risk investments to buy safer options, like Treasuries. With the increase in demand for the safer Treasuries, the less interest the Government needs to pay to entice investors to buy the bonds. This causes the long end of the yield curve to drop.
So why do we care about this chart? Historically, when the yield curve has inverted, it has foreshadowed a future recession. An inverted yield curve is perceived as a leading indicator of an economic downturn. As a matter of fact, the yield curve was inverted before the past seven recessions.
While this finding is striking, it doesn’t mean a recession is certain. Looking back in history, there have been multiple yield curve inversions globally that did not precede a downturn. It is also important to remember that in an ever-changing economy, past events do not necessarily predict the future. The other two variables that are often cited as predictors of recessions are increasing inflation and rising unemployment. These two indicators are giving us opposite signals. Some economists say that this time is different due to the flood of yield-starved investors from around the globe drawn to U.S Treasuries. Since rates across the globe are low and the U.S. has some of the highest rates available, those who rely on bonds for income, including international investors and foreign governments, are flocking to U.S. bonds, depressing our long-term rates.
It is impossible to know how far off we are from the next recession or how severe it will be. Therefore, it is imperative to have a fully diversified portfolio paired with a sound investment philosophy to guide you through any outcome. We cannot rule out the possibility a slowdown is close at hand, but the U.S. could just as easily stay at 4% unemployment for the next few years, postponing any economic contraction.