Today, August 14, 2019, the main part of the yield curve inverted. This is an important event because an inverted yield curve has historically been a very good predictor of a coming recession. In this article we will review
- What the yield curve is
- What it means when the yield curve inverts
- Historical data showing why it’s been a good predictor of recessions
- What it means for investors today
Understanding the Yield Curve
The yield curve is an economic indicator that originates from the bond market. It’s basically a chart that shows the yield of government bonds at different durations. For example, the yield on a two-year treasury note versus a 10 year government bond. In a healthy economic environment, the curve is positively sloped as is illustrated by the chart below.
In a positively sloped yield curve, longer-term bonds have higher yields. Here’s a hypothetical example using CDs. Let’s say you go into that bank and you are trying to decide between buying a 1 year CD or a 5 year CD. In most cases you would naturally expect the 5 year CD to give you a higher level of interest because the bank is locking up your money for 5 years instead of 1 year. If a 1 year CD gives you 1% interest, you might expect a five-year CD to give you 3% interest in a bond market that has a positively sloped yield curve, because the further you go out in duration, the higher the current yield.
However, sticking to our hypothetical example using CD’s, there are periods of time when you go into the bank and the 1 year CD has a higher interest rate than a 5 year CD. That would make you ask the obvious question, “Why would anyone to buy a 5 year CD at a lower interest-rate than a 1 year CD? You get a higher investment return on your money for the next year and you get your money back faster?”.
The answer is as such, in the bond market, investors will sometimes buy bonds for a longer duration at a lower current yield because they expect a recession to come. When a recession hits, typically the Federal Reserve will start lowering interest rates to help stimulate the economy. When that happens, interest rates typically drop. Anticipating this drop in interest rates, bond investors are willing to buy bonds today that lock up their money for a longer period of time with a lower yield because they expect interest rates to drop in the near future.
So, let’s use the hypothetical CD example again. You go into the bank and the 1 year CD rate is 3% and the 5 year CD rate is 2.5%. In an inverted yield curve situation, investors are buying those 5 year CD’s even though they have a lower interest-rate, because when the recession hits and the Fed starts lowering interest rates when that 1 year CD matures a year from now, the new rate on CD’s may be a 1 year CD at 1% and 1.5% on a 5 year CD. So from an investment standpoint today, it’s a better move to lock in your 2.5% interest rate for 5 years even though the yield is lower than the 1 year CD today. You can see in this example why an inverted yield curve is such a bearish signal for the markets.
Below is an illustration of an inverted yield curve:
It’s a Very Good Predicator of Recessions
When you look at the historical data, it shows how frequently an inverted yield curve has preceded a coming recession. Below is a chart that shows the spread between a 2 year government bond and a 10 year government bond. The yield curve is positively sloped when the blue line is above the dark black line. When the blue line falls below the dark black line, that means that the yield curve is inverted. The grey areas in the chart indicate recessions.
Today, the main part of the yield curve which means the 2 year vs the 10 year bonds inverted. However, it’s important to point out that earlier in 2019, the yield on the 10 year treasury bond dropped below the yield on the 3 month treasury note, so technically this is the second time the yield curve is inverted in 2019.
What Does That Mean for Investors?
If we use history as our guide, the inverted yield curve is a caution light for investors. Historically, the main question people ask next is, “How long after the yield curve inverts does the recession usually begin?”. Here is the chart:
As you can see, the problem with using this data to build an estimates timeline until the next recession is the variance in the data. Even though, in the past 5 recessions, the “average” period of time between the inversion of the yield curve and the subsequent recession was about 12 months, in 2 out of the 5 recessions, the inversion happened within 2 months of the beginning of the next recession. Timing the markets is very difficult and as we get into the later innings of this long economic expansion, the risks begin to mount. For this reason, it very important for investors to revisit their exposure to risk asset to make sure they are properly diversified.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.