Making Sense of the Yield Curve
"Investing isn't about beating others at their game. It's about controlling yourself at your own game." - Benjamin Graham
Well, it finally happened—the yield curve inverted. This simply means that some short-term interest rates are higher than some longer-term rates. In a “normal” rate environment, investors are only willing to invest longer term for a higher rate.
This is a topic that the news media will love to print sensational headlines, predicting the next recession. Many suggest an inverted yield curve is the bond market’s way of saying there is the potential for a recession somewhere on the horizon. However, an inverted yield curve has also predicted many recessions that have never occurred.
However, it is also one of those cases where there is simply “more to the story.”
Here are 8 things worth understanding about the yield curve:
- Although a yield curve inversion preceded all 9 previous recessions, not all inversions led to a recession. For instance, the 3-month/10-year yield curve inverted in 1966 and 1998, with neither leading to an immediate recession. In each of the past 9 recessions going back to 1950, the yield curve inverted approximately 14 months prior to the start of a recession.
- Presently, the shorter end of the yield curve has inverted, but the longer end has not. The 10-year/30-year yield curve has steepened most of this year. Contrarily, in past recessions, all parts of the curve inverted before a recession took place.
- Financial conditions are not tight, and historically it has been the combination of both tight conditions and the yield curve inverting, that has led to a recession.
- The fed funds rate has been significantly higher during previous inversions. In fact, the fed funds rate has averaged more than 6% when the 1-year/10-year yield curve has previously inverted. Currently, it is only 2.40%.
- The previous 5 recessions started an average of 21 months after the 2-year/10-year yield curve inverted. Stocks actually did quite well initially after inversions, with the S&P 500 Index not peaking until over a year after the inversions and gaining nearly 22% on average at the peak.
- As a recent LPL Chart shows, the S&P 500 has actually outperformed the average year the previous three times the 2-year/10-year yield curve inverted.
- Various yields around the globe continue to sink, with over $13 trillion in global debt now yielding less than 0%. We believe this has forced many to look to the United States as a safe haven for sovereign debt, thus pushing our yields much lower along the way.
- Yield curves have a history of being imperfect: Japan has had long stretches of inverted curves that did not lead to recessions. Additionally, both the United Kingdom and Germany have had inversions without recessions.
So Now What?
U.S. Economy Remains on Solid Footing
Even though we are alert to the yield curve’s shape right now, we see few signs of danger ahead. Data shows the U.S. economy is on solid footing, and corporate debt spreads remain contained in this latest bout of volatility. Financial monetary policy conditions are still historically loose, yet there are few signs of excess in the financial system. The labor market is at full employment, the consumer is spending, and corporate profits are at record levels. Further, U.S. stocks have also been resilient against yield curve inversions in the past. Historically, the S&P 500 Index has rallied an average of 22% from the first inversion to the eventual economic peak.
So Why Do We Have an Inversion Now?
We must keep a Global Perspective to see why we have an inverted curve. The US bond market has what is considered right now by many to be the safest and best paying bonds relative to global bonds, which are paying negative yields. The past couple weeks have had a handful of negative headlines that are causing people to want to buy bonds: Hong Kong riots, Russian nuclear accident, ongoing Chinese Trade war, Iran messing with oil tankers, North Korea testing missiles. However, we have had negative headlines every year. What is different this year is, the negative international bond rates are causing investors to buy US bonds. When prices go up in bonds because of higher demand, the interest rate yields come down. Therefore, we believe the supply and demand imbalance has led to a distortion in the interest rate environment.
So What Does A Recession Look Like?
Of course, recessions can be self-fulfilling prophecies of market sentiment. However; historically, recessions onset when 2 of 3 things occur: A.) Aggressive Federal Reserve Policy, B.) Spike in Commodity Prices and/or C.) Equity Valuations at Extreme Valuations. Remember in 2008, we had Aggressive Federal Reserve Policy & Spike in Commodity Prices. And in 2001, we had Equity Valuations at Extreme Valuations & Spike in Commodity Prices. Today, we don’t see any of these three conditions.
Yes we will have another recession one day, but the inverted yield curve is not a good indicator to tell us when.
Remember our door is Open – We do not believe the current news headline is a reason changes to long term plans. There has not been any change to our long-term market indicators. If you want to set up a call or a visit to discuss anything related to your financial life, please let our team know how we can be of service.