What is an Inverted Yield Curve and Why Should I Care?

September 6, 2019

 

Lately there has been much attention in the media (and from us) about the Yield Curve Inversion we are currently experiencing.  Simply speaking a Yield Curve Inversion exists when yields on longer term bonds are lower than shorter term bonds.  In almost all cases this refers to the yields on US Treasury Bonds.

 

Here’s the boring detailed explanation: Historically, the US Treasury yield curve has most often been upward sloping, with longer-dated bonds offering higher yields than shorter-dated bonds. However, there have been periods when the yield curve was downward sloping, during which longer bonds were lower yielding than shorter bonds. A common concern for investors is that a yield curve inversion, or transition from upward to downward sloping, could be a precursor to a decline in equity markets.

 

While inversions have preceded recessions in almost all cases, the timing of the recession and any associated downturn in equity prices have a strange relationship.  The 2008 financial crisis offers one example to drive this point home. The US yield curve inverted in December 2005, after which the S&P 500 Index posted a positive 12-month return. The yield curve returned to a positive slope in June 2007, well prior to the market’s major downturn from October 2007 through February 2009.

 

Our current inversion is more associated with market forces driving down longer-term rates versus the raising of short-term rates by the Federal Reserve that predicated the inversion in 2005.  This is most unusual.  Further, the US Central Bank (the Fed) and other foreign Central Banks are still engaged in Quantitative Easing (QE) programs (buying up bonds in the market to maintain liquidity and reduce interest rates) that have helped us recover from the financial crisis some 10 years ago.  These moves were unprecedented so there is no way to tell their effect combined with a yield curve inversion. Only time will tell.

 

What should investors do?  As usual, we recommend having a plan and sticking to it.  A balanced diversified portfolio is built to expect and withstand temporary moves in stock and bond prices.

 

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