- What is an Inverted Yield Curve—and Why Are People Talking About It?
- Does an inverted yield curve always signal a recession?
- Why do treasury bonds matter so much?
- How worried should I be about an inverted yield curve?
- So, what should I do?
- Yield Curve Inversion: What Is It, Why It Matters and What to Do Now
- What Is a Yield Curve Inversion?
- Why Does It Predict Recessions?
- What Usually Happens After an Inversion?
- What’s Going to Happen Now?
- Bottom Line
- Predicting Recessions Using the Yield Curve: The Role of the Stance of Monetary Policy
- The Relationship between the Yield Curve and Future Recessions
- Evaluating the Yield Curve’s Predictive Power
- Countdown to recession: What an inverted yield curve means
- WHAT IS THE TREASURY YIELD CURVE?
- WHAT IS A CURVE INVERSION?
- WHY DOES INVERSION MATTER?
- WHY DOES THE CURVE INVERT AT ALL?
What is an Inverted Yield Curve—and Why Are People Talking About It?
An inverted yield curve is an economic indicator that can cause investors and economists to worry that a recession is looming.
“Yield” refers to the expected return on an investment over a set period of time, and the yield curve is a graph that depicts the yields of U.S.
Treasury bonds at different maturities, ranging from several months to 30 years.
“The chart helps set expectations for investors to see what they can earn on a bond over time,” says Timothy Chubb, CIO at Girard, a wealth advisory firm in King of Prussia, Penn.
On a normal yield curve, the longer-term bonds will show a higher return than the shorter-term bonds. Just if you purchase a CD at the bank, you'd expect to earn a higher interest rate on a five-year CD than on a one-year CD because you’re locking your money up for a longer time period.
When a yield curve is inverted, that means the expectations have flipped: Shorter-term bonds are providing a higher return than longer-term bonds. For instance, when the yield for a 10-year Treasury bond falls below the yield for a two-year Treasury bond, economists take notice.
“A yield curve matters because it could be an indicator of the economy slowing down and a possible recession,” says Glen Smith, financial advisor for Raymond James Financial in Flower Mound, Texas. “This could potentially bring a downturn for stocks.”
People get worried about an inverted yield curve on U.S.
Treasury bonds because it indicates investors are so worried about the near-term future that they are putting their money into what they view as safer long-term bonds instead.
And, perhaps, with good reason. The last nine times the inverted yield curve happened, a recession followed. In fact, it’s inverted before every recession since 1955.
The recessions didn’t happen immediately after, though. On average, it has taken about 19 months for a recession to hit following this indicator, says Tony Matheson, CFP, founder and wealth advisor, Matheson Financial Partners in Walnut Creek, Calif.
Does an inverted yield curve always signal a recession?
Not necessarily. There’s no definitive way to predict a recession. Even though the yield curve has inverted before every recession for the past 65 years, that doesn’t mean it will happen every time.
Economists and financial experts are actually debating whether an inverted yield curve is still an important indicator. Until recent years, nobody was really watching the yield curve as a predictor of recessions, and now that it’s getting so much attention, it may not be as reliable.
In science, the “observer effect” means that behavior can change when the object is being observed. The same principle may hold true for an inverted yield curve. “Now that everyone is observing this indicator, there’s a question about whether it really still means what it used to mean,” Matheson says.
Also, when inverted yield curves preceded recessions in the past, it was in a very different interest rate environment, Matheson says. “We’re at a historically low 2 percent, and in times past, interest rates have been around 6 percent or higher when this happened.”
The Federal Reserve, our country’s central bank, lowered what’s called the Fed funds rate—the interest rate at which banks make overnight loans to each other—to a target range of 1.75-2 percent on Sept. 18. When that rate goes down, so do the costs of borrowing money, which can encourage more consumer spending and boost the economy. But, back to bonds…
Why do treasury bonds matter so much?
Whe someone buys a U.S. Treasury bond, they’re essentially loaning money to the U.S. government to be paid back at a certain rate of interest over a certain length of time. Because treasury bonds are backed by the U.S. government, they are viewed as the safest investment.
For that reason, treasury yields are watched closely and viewed as a gauge to predict other types of investments, investor confidence and economic outlook.
Traditionally, the treasury bond market can be an indicator of investor confidence.
When yields are low, it’s usually because demand is low—and demand is low because the economy is doing well and investors want to invest in other products that earn a higher return.
When yields are high, demand is high because investors are worried about the market and want to put their money in a safe place.
However, the treasury market’s yield curve isn’t always a straightforward indicator of the U.S. economy. When other bond markets around the world lag due to political unrest, conflict and uncertainty, foreign investors may flock to the U.S. bond market instead.
All that sudden foreign investment can distort the treasury market’s yield curve, says David Armstrong, CFA, president and co-founder of Monument Wealth Management in Alexandria, Va. In that case, the standard interpretation that high bond yields signal low confidence among U.S. investors may not be correct.
How worried should I be about an inverted yield curve?
Even if a recession is on the horizon, it ly won’t occur immediately. Remember: Over the past 60 years, every yield curve inversion occurred at least 18 months before a recession. The three-year and five-year treasury bonds inverted in December 2018, and the two-year and 10-year treasury bonds inverted in June 2019 and then again later in the summer.
In the weeks following the inversion at the end of August, it righted itself. Still, even if the yield curve doesn’t indicate a recession on the horizon, it does ly imply that slower growth is ahead and “volatility is back,” Matheson says.
So, what should I do?
In a more volatile environment, investors should expect more frequent dips in the market. That means it’s more important than ever to diversify your portfolio, spreading your money across a range of different types of stocks and bonds.
One way to do that is with stock and bond funds exchange-traded funds, or ETFs, which provide broad exposure. That way, if one sector experiences a steep drop, your whole portfolio won’t go with it.
(Acorns portfolios contain at least seven funds with exposure to thousands of stocks and bonds.)
If you’re investing for the long term, don’t worry too much. Recessions generally don’t last as long as expansions do. Since 1900, the average recession has lasted 15 months. While stock market downturns vary in length, they’re typically much shorter than periods of growth, too. And every market downturn in history has ended in an upturn.
Investing involves risk including loss of principal. This article contains the current opinions of the author, but not necessarily those of Acorns. Such opinions are subject to change without notice.
This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
Yield Curve Inversion: What Is It, Why It Matters and What to Do Now
Amid the Dow Jones Industrial Average dropping 2,000 points in two days (its biggest two day drop, ever) on concerns that the coronavirus is rapidly expanding outside of China and turning into a pandemic, you probably missed something that would otherwise be dominating financial headlines everywhere. That is, in mid-February, Wall Street’s favorite recession indicator — a yield curve inversion — appeared, again, for the second time in seven months.
A yield curve inversion happens when long-term interest rates fall below short-term interest rates, indicative that investor demand for long-term fixed income instruments is unusually high and expectations for near-term economic growth are unusually low.
It’s a scary sign. A yield curve inversion has successfully predicted every U.S. recession since 1930.
So, with the yield curve inverted, the coronavirus gradually turning into a global pandemic, and the bull market in its eleventh year, is it time to call it one heck of a run, and take profits off the table?
I don’t think so. Not yet, at least.
But, in order to understand why, let’s take a step back and answer some basic questions. What exactly is a yield curve inversion? Why does it predict recessions? What normally happens after an inversion? What’s different this time around?
Let’s answer all those questions, and more, in this guide to understanding a yield curve inversion and what it means for your money today.
What Is a Yield Curve Inversion?
The yield curve inverts when long-term interest rates fall below short-term ones.
That is an abnormal circumstance in financial markets. Normally, short-term interest rates are below long-term interest rates, indicative of the fact that investors require more return for keeping their money tied up for longer.
But, when investors expect that a slowdown is coming, they don’t care about getting more return for keeping their money tied up. They just want to lock in yield. So, they pile into instruments with the best yields, which are long-term fixed income instruments. That flight into safe-haven assets pushes long-term bond prices up.
When prices go up, yields go down, and this causes a yield curve inversion.
Why Does It Predict Recessions?
A yield curve inversion is considered a reliable recession indicator on Wall Street for two reasons.
First, it’s the bond market telling you something. Many people forget this, but the bond market is actually bigger than the stock market. The global capitalization of the stock market is about $85 trillion. The global bond market measures in around $100 trillion. When $100 trillion is trying to tell you something, you should listen.
A yield curve inversion is that $100 trillion market telling you that a slowdown is coming, and that it’s time to lock in yield wherever you can find it.
Second, the yield curve has a history of getting it right. Since 1930, a yield curve inversion has successfully predicted every U.S. recession. The timing hasn’t always been perfect (more on that later). But, it has never failed to predict a major slowdown.
What Usually Happens After an Inversion?
While yield curve inversions do tend to predict recessions, they are also notoriously premature.
Both my research and research from LPL Research show that yield curve inversions are actually a near-term bullish, medium-term bearish sign for stocks.
Specifically, a full yield curve inversion — typically defined by the 10-Year Treasury yield falling below the 2-Year Treasury yield — has only happened a handful of times over the past 50 years.
Yes, each inversion successfully predicted a recession. But, on average, the stock market didn’t peak until about 20 months after the inversion happened.
During those 20 months, stocks tended to post outstanding returns, with average returns north of 25%.
So, yield curves do predict recessions, but they tend to be about 20 months early, and history says you don’t want to sit out those 20 months.
Also of note, the big thing to watch is the 2-Year Treasury yield. Immediately prior to each stock market peak in the past thirty years, the yield curve actually normalized into the peak, driven by a plunge in the 2-Year Treasury yield on bond market expectations that rates were going to get cut multiple times to help thwart a forthcoming slowdown.
What’s Going to Happen Now?
The yield curve inversion is something to note. But, it’s nothing to freak out about. Yet.
We are only seven months from the 10-2 yield curve inversion in August 2019, and in the middle of the February inversion. That doesn’t line up with how these things work historically.
You don’t get market peaks when everyone is freaking out about a yield curve inversion. You get market peaks when everyone forgets about the yield curve inversion, and animal spirits take over. Normally, it takes about 20 months for that to happen.
That timing pegs the next market peak in the second quarter of 2021.
At the same time, the 2-Year yield is falling, but not plunging it has before prior recessions. Until that plunges on expectations for huge rate cuts, there really isn’t much cause for concern here.
In other words, the yield curve is flashing warning signs right now — but no stop signs.
Fundamentally, I agree with the yield curve. The economy and the market have some warning signs, such as the coronavirus outbreak and slowing global growth. But, the core fundamentals remain pretty solid. Labor markets are healthy. Spending conditions are favorable. Businesses are growing. Central banks are injecting liquidity.
The fundamentals are still pretty good. So long as that remains true, this bull market ly won’t die.
Yield curve inversions are scary. The February inversion is no different. It’s scary.
But, it’s warning sign, not a stop sign. Be cognizant of the building risks in financial and equity markets. But don’t ditch stocks. This bull market isn’t over yet.
Luke Lango is a Markets Analyst for InvestorPlace. He has been professionally analyzing stocks for several years, previously working at various hedge funds and currently running his own investment fund in San Diego.
A Caltech graduate, Luke has consistently been rated one of the world’s top stock pickers by TipRanks, and has developed a reputation for leveraging his technology background to identify growth stocks that deliver outstanding returns.
Luke is also the founder of Fantastic, a social discovery company backed by an LA-based internet venture firm. As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
Predicting Recessions Using the Yield Curve: The Role of the Stance of Monetary Policy
Recessions are difficult to predict, in part because they occur rarely, but also because the factors that drive the economy into a recession most ly differ across episodes. As a consequence, a factor that may drive one recession may fare poorly in predicting other downturns.
Using many explanatory variables to estimate the probability of recessions will ly result in a very limited ability to predict recessions outside the estimation sample.
In contrast, the slope of the yield curve has proven a promising parsimonious indicator of downturns, possibly because a variety of factors, some of them complementary, can drive a yield curve inversion and at the same time carry information about a future recession.
The Relationship between the Yield Curve and Future Recessions
The slope of the yield curve is typically measured by the “term spread,” that is, by the difference between the yields on long- and short-term Treasury securities.
A common measure of the term spread, and the one we focus on here, is the difference between the 10-year Treasury bond yield and the 3-month Treasury bill yield.
A yield curve inversion occurs when the spread is negative—when the long-term yield is less than the short-term yield.
Several factors can drive a yield curve inversion. Most common is when the central bank temporarily increases the short-term interest rate and the long-term rate rises less than proportionately (because it embeds expectations that future short-term rates will eventually revert to lower levels).
Thus as tighter policy works its way through the economy, the restrictive monetary policy stance can generate an inverted yield curve today and weaker activity in the future. This does not imply that monetary policy is necessarily the sole or primary cause for a recession.
For example, forecasts from the Federal Reserve Board staff before the onset of the three most recent recessions, as dated by the National Bureau of Economic Research (NBER), show that actions taken to tighten the stance of monetary policy were intended to slow the economy to a more sustainable pace of growth, not to purposely tip the economy into a recession.
4 This does not rule out that the Board staff could have misjudged the effect of policy tightening on economic activity, or the underlying resilience of the economy. It is also possible, however, that a policy action meant to slow the pace of growth to a more sustainable level was exacerbated by exogenous and unanticipated adverse factors.
While this implies systematic bad luck striking precisely at the time of tight monetary policy, it is also true that slower growth makes the economy more vulnerable to adverse shocks, thus raising the lihood of a recessionary event.
A yield curve inversion can also emerge due to a decline in longer-term interest rates. Investors’ expectations about future economic activity, and the associated expectations about future monetary policy, will drive movements at the longer end of the curve.
For example, an anticipated slowdown in the pace of economic activity will put downward pressure on long-term yields, because they are driven by expectations of future short-term rates, and investors recognize that the central bank will have to lower rates eventually if the slowdown materializes. Such a decline in long-term yields can generate a yield curve inversion that is correlated with a future recession to the extent that investors correctly anticipate the downturn. Needless to say, theses dynamics could also occur in the context of the previously described monetary policy tightening scenario.
Changes in risk assessments of the future state of economic activity can also affect long-term rates and lead to an inverted yield curve.
Indeed, long-term Treasury bonds are an effective hedge against states of the world with low economic activity, as (long-term) interest rates tend to be depressed when activity is low, and so bond prices appreciate when activity is depressed (recall that the price of a bond is inversely related to its yield).
When risks of a future downturn increase, even with an unchanged modal path for the future course of monetary policy, there can be a “flight to quality” that bids up the price of long-term Treasury bonds and lowers their yield.5 Thus if a recession materializes, it will be correlated with the inverted yield curve.
In sum, many non-mutually exclusive channels could rationalize why the yield curve has predictive power for future economic activity.
In particular, the yield curve aggregates information from a host of sources and captures investors’ expectations about the economy’s future prospects, which are driven by factors that can change over time.
Importantly, the yield curve also incorporates information about the stance of monetary policy, which is tied to where the economy stands in the business cycle and could be informative about the lihood of a future downturn.
Relative to other financial market indicators, such as broad stock market indices, that the literature shows to have, at times, predictive power for future economic activity, the yield curve has the advantage of more readily providing additional information about investors’ perceptions of risks.
Evaluating the Yield Curve’s Predictive Power
It is certainly debatable whether the aforementioned reasons for the predictive power of the yield curve are compelling. After all, investors can be wrong about future economic developments, and monetary policy tightening that inverts the yield curve should not necessarily translate into an economic downturn.
Indeed, the yield curve is frequently used to predict recessions in large part because it seems to work in practice.
While the literature reaches different conclusions about which segment of the yield curve has the greatest predictive power (see Miller 2019), there is much less debate about the general usefulness of the yield curve as an indicator of future US recessions.6
There is much less consensus, however, on what role monetary policy plays in the yield curve’s predictive power. Wright (2006), for example, finds that the term spread, as a summary measure of the yield curve, owes its predictive power for future recessions, at least in part, to the stance of monetary policy.
Bauer and Mertens (2018) argue the opposite—that the ability of the yield curve to predict recessions has little to do with the stance of monetary policy.
These and other studies, however, do not gauge the stance of monetary policy vis-à-vis a time-varying neutral federal funds rate (neutral rate)—the rate that, absent any shocks, will keep the economy at equilibrium.
7 Their implicit assumption of a constant neutral funds rate runs against evidence by Laubach and Williams (2003 and subsequent updates), which shows that the estimates of the neutral (or natural) short-term real rate of interest, while imprecise, tend to exhibit significant variation over time. Moreover, Fuhrer et al.
(2018) document that the Federal Open Market Committee’s implicit inflation target, which affects estimates of the neutral rate, was also time-varying until 1996, when the FOMC implicitly adopted a 2 percent target; the committee explicitly adopted the 2 percent target in 2012.
In principle, changes to the real and inflation components of the neutral federal funds rate could offset each other and result in a constant (nominal) neutral rate. However, there is little reason to expect that this is the case in practice.
In the next section we define our measure of the time-varying neutral rate and show how the predictive power of the yield curve for future recessions is affected by the relative stance of monetary policy measured in a way that takes into account time-variation in the real neutral rate and in the FOMC’s inflation target.
Countdown to recession: What an inverted yield curve means
By Karen Brettell
NEW YORK – A dramatic rally in Treasuries this week led some key parts of the U.S. yield curve to reinvert, a signal that has traditionally been bearish for the U.S. economy.
FILE PHOTO: A trader works on the floor at the New York Stock Exchange (NYSE) in New York, U.S., August 9, 2019. REUTERS/Brendan McDermid
The curve between two-year and five-year notes inverted on Monday for the first time since December, and the three-month, 10-year curve briefly turned negative on Tuesday for the first time since October.
Long-dated yields dropped as fears over the economic impact of China’s coronavirus led investors to seek out safe-haven assets.
The move has offset optimism heading into the year that growth and inflation would pick up, after the United States and China in December agreed to de-escalate their trade war.
The gap between three-month and 10-year yields is closely watched. An inversion, when 10-year yields fall below those on three-month bills, has in the past been a reliable indicator that a recession will follow in one to two years.
This part of the yield curve inverted last March for the first time since the 2007-2009 financial crisis.
The very front of the curve remained kinked, with bills yielding more than shorter-dated notes 2-year, 3-year and 5-year maturities. However, those relationships are not as closely monitored as economic bellwethers.
Still, while a recession may be ly to follow an inversion, the timing is uncertain, and loose monetary policy globally could result in any downturn taking longer to materialize.
Some analysts also think that the relative attractiveness of U.S. bonds to those in Europe and Japan, many of which have negative yields, is keeping longer-dated yields below where they would otherwise be, reducing the accuracy of the yield curve inversion as a recession signal.
WHAT IS THE TREASURY YIELD CURVE?
The yield curve is a plot of the yields on all Treasury maturities – debt sold by the federal government – ranging from 1-month bills to 30-year bonds.
In normal circumstances, it has an arcing, upward slope because bond investors expect to be compensated more for taking on the added risk of owning bonds with longer maturities.
When yields further out on the curve are substantially higher than those near the front, the curve is referred to as steep. So a 30-year bond will deliver a much higher yield than a 2-year note.
When the gap, or “spread”, is narrow, it is referred to as a flat curve. In that situation, a 10-year note, for instance, may offer only a modestly higher yield than a 3-year note.
WHAT IS A CURVE INVERSION?
On rare occasions, some or all of the yield curve ceases to be upward sloping. This occurs when shorter-dated yields are higher than longer-dated ones and is called an inversion.
While various economic or market commentators may focus on different parts of the yield curve, any inversion of the yield curve tells the same story: An expectation of weaker growth in the future.
In March, inversion of the yield curve hit 3-month T-bills for the first time in about 12 years when the yield on 10-year notes US10YT=RR dropped below those for 3-month securities.
It has traded in positive territory since October, with the exception of Tuesday’s brief inversion.
The curve between 2-year and 10-year notes, which is also watched as a recession indicator, inverted for the first time since 2007 in August. It has been positive since early September.
(Graphic: Yield curve inversions typically precede recessions, )
WHY DOES INVERSION MATTER?
Yield curve inversion is a classic signal of a looming recession.
The U.S. curve has inverted before each recession in the past 50 years. It offered a false signal just once in that time.
When short-term yields climb above longer-dated ones, it signals short-term borrowing costs are more expensive than longer-term loan costs.
Under these circumstances, companies often find it more expensive to fund their operations, and executives tend to temper or shelve investments. Consumer borrowing costs also rise and consumer spending, which accounts for more than two-thirds of U.S. economic activity, slows.
The economy eventually contracts and unemployment rises.
WHY DOES THE CURVE INVERT AT ALL?
Shorter-dated securities are highly sensitive to interest rate policy set by a central bank such as the U.S. Federal Reserve.
Longer-dated securities are more influenced by investors’ expectations for future inflation because inflation is anathema to bond holders.
So, when the Fed is raising rates, as it did for three years, that pushes up yields on shorter-dated bonds at the front of the curve. And when future inflation is seen as contained, as it is now because higher borrowing costs are expected to become a drag on the economy, investors are willing to accept relatively modest yields on long-dated bonds at the back end of the curve.
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