The Dreaded Inverted Yield Curve

Let’s start with why we care about this thing known as an Inverted Yield Curve.  First, the Inverted Yield Curve has predicted all seven recessions since the 1960s.  Second, recessions lead to negative consequences for the U.S. stock market.

Having said that, it is appropriate to note that just last week Janet Yellen suggested that if the yield curve does become inverted, this time will be different.  Specifically she noted

“Now there is a strong correlation historically between yield curve inversions and recessions…..But let me emphasize the correlation is not causation.”

Now that you know why we care, let’s back up and explain what a basic Yield Curve is. According to Investopedia, a yield curve “is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the yield paid [current interest rate] on the three-month, two-year, five-year and 30-year U.S. Treasury debt.” Typically, investors expect to get paid a higher yield for longer maturities because of the uncertainty over what could happen to the value of the bond over a longer term.

An Inverted Yield Curve, on the other hand, occurs when short term yields rise above longer term yields of equivalent credit quality. This results from unusual demand versus supply of long-term and/or short-term credit. In this situation, either investors demand higher rates on shorter term bonds because they anticipate short term rates to continue to go higher, and/or other investors will buy longer term bonds to lock in those rates when they believe these rates will decline in the near future. From a supply perspective, an Inverted Yield Curve may signal that lenders have little confidence in the economic outlook.

Here are graphic examples of both yield curves:

Market watchers often look at the spread between 2-year and 10-year notes as a short-hand way to monitor the yield curve. The chart below shows the 2-year/10-year spread going back to the 1970s. Gray bars indicate recessions. When the spread turned negative the yield curve inverted. Note that each recession occurred after the Yield Curve inverted.

Now, if are you still reading to this point (not asleep or you switched off this warm and fuzzy topic), you may have noticed that the current data in the chart above slopes decidedly downward and hints at inversion, possibly next year. Why? Well, for starters, the Federal Reserve increased short-term U.S. interest rates (the Fed Funds rate) four times since December 2016, most recently just last week.  And they signaled three additional short term rate increases in late 2018. At the same time, however, investors continue to bid up the demand for longer term bonds based on low expectations for inflation combined with even lower competitive rates outside the U.S.

After all of this you should know that we remain committed to diversification and risk control of portfolios.  Should the U.S yield curve invert and a recession ensue we will help clients adjust portfolios accordingly.

Craig Forbes, CIMA®, is the Co-Principal and Founder of Alpha Omega Wealth Management. Craig has over 25 years of experience in the banking and financial services industry.  For feedback or questions regarding this blog post, please contact Craig at craig@aowealth.com.