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Should Investors Stress Over an Inverted Yield Curve?

Posted by Doug Hutchinson | CFA®, Director of Research and Trading
August 21, 2018

Do Not Stress the Inverted Yield Curve and Its Recession Predicting Powers-367068-editedDespite Apple topping $1 trillion in market value, the unemployment rate continuing to climb down, and a multitude of other positive market indicators, the Treasury yield curve has begun worrying some market analysts. That said, we don’t feel that investors should worry too much about an inverted yield curve. Here’s why…

The Treasury Yield Curve as an Indicator of Recession

The Treasury yield curve is typically upward sloping where long-term yields are higher than short-term yields. The longer the time to maturity, the higher the risk to the bondholder since the longer-term bonds have a longer time horizon and are therefore exposed to more potential changes in interest rates than short-term bonds. This forces investors in long term bonds to seek higher yields in exchange for accepting the added risk of a longer maturity bond.

What is the Treasury yield curve? The U.S. Treasury Yield Curve compares the yields of short-term Treasury bills (those with terms of less than a year) with long-term Treasure notes and bonds (notes have terms of two, three, five, and 10 years while bonds have terms of 20 or 30 years). Yields always move in the opposite direction of Treasury bond prices because low demand drives the price below the face value while high demand drives the price above face value.

The yield curve becomes inverted when short-term yields are higher than long-term yields. An inverted yield curve does not happen very often, but it has preceded every recession in the U.S. for the last 50 years.1

What Causes an Inverted Yield Curve?

A yield curve might become inverted if investors are worried about the strength of the economy in the future. If an investor is willing to accept a lower interest rate in the future it is likely because they expect economic growth to be weak (or negative) in the future and that the central bank will reduce interest rates in the future to try to spur economic growth.

There is typically some nervousness among investors when the yield curve is flattening and could be heading toward inverting.

At the end of July, the yield on the 3-month Treasury bill was 2.00% while the yield on the 10-year Treasury bond was 2.86% (a spread of 86 basis points).2 This is still an upward sloping yield curve although the yield curve is flatter than at the end of June where the yield on the 3-month Treasury bill was 1.94% while the yield on the 10-year Treasury bond was 2.91% (a spread of 97 basis points).2

What Should Long-Term Investors Do About an Inverted Yield Curve?

An inverted yield curve should not be viewed as a signal to sell equities. While it is true that the yield curve inverted prior to the housing crash and recession of 2008, the inversion occurred in January of 2006 – 20 months before the S&P 500 peaked in October 2007. An investor who sold out of equities in January of 2006 would’ve missed out on a 22% price return from January 2006 to the peak in October 2007.3 Likewise, an investor who sold out of equities in May 1998 when the yield curve inverted would’ve missed out on a 39.6% price return on the S&P 500 between May 1998 and the peak in March 2000.3

Interestingly, the yield curve inversion always preceding a recession rule of thumb has not held up outside of the U.S. For example, Japan has not had an inverted yield curve since 1991 but Japan has had multiple recessions since 1991.4 The yield curve in Australia has inverted four times since 1990 but Australia has only experienced one recession since 1990.4

For a long-term investor who would otherwise remain invested, taking an inverted yield curve as a signal to sell can be detrimental. While an inverted yield curve is a potential predictor of a future recession, the future recession could be months or even years away. Timing the market is extremely difficult and you run the risk of selling too early and missing out on positive performance from being out of the market. As JP Morgan points out in the chart below, missing out on the 10 best days of the market in a given year could reduce your total return for the year by more than half. By extension, missing out on the 20, 30, or even 60 best days continues to negatively impact your returns, eventually even eating away the initial investment by more than 6%.

Impact of Being Out of the Market as of June 30 2018 - JPM GTR

It’s important to note that an inverted yield curve isn’t viewed as a cause of a recession, just as a potential warning sign of a recession. In addition to the fact that the yield curve hasn’t actually inverted yet, there are currently few warning signs of an imminent recession.

Corporate profits remain strong and are forecast to remain strong:

Corporate Profits as of June 20 2018 - JPM GTM

Moreover, unemployment remains very low (3.9% in July 20185) and well below the 50-year average unemployment rate of 6.2%6 and the initial estimate of GDP growth in the second quarter was 4.1%, the fastest pace since 2014.7

Again, the U.S. yield curve has been flattening but hasn’t yet inverted. Even if the yield curve does invert, there is no guarantee that a recession will follow in the next month, the next year, or the next five years. The best course of action for long-term investors is to understand what an inverted yield curve means and look to their long-term investment plan for the best course of action.

If you are concerned about how your portfolio would fare in a recession however, our wealth managers are more than capable of helping you evaluate the amount of risk in your existing investments. To begin the process of reviewing your existing investment portfolio, please request your detailed investment plan now.

 

 

Sources

1 Federal Reserve Bank
2 Federal Reserve Bank of Cleveland
3 LPL Research, FactSet via MarketWatch
4 AQR
5 NPR
6 JP Morgan Guide to the Markets as of June 30, 2018, Page 25
7 CNBC

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