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

There has been a lot of recent press about the inverted yield curve so without getting too geeky, I thought I would learn something about it and then share with all of you. The answer to “what it is” is much easier than the answer to “why should I care”.

Easy question first…

In a normal economic world, there is a lot more uncertainty in the economic outlook 30 years from now than there is 2 to 3 years from now. To compensate for that uncertainty and risk, borrowers pay more for long term 30 year Treasuries than for shorter term ones. The result is that we as the bondholders normally get paid higher interest rates for longer term bonds of equal credit quality. In an inverted yield curve world, some shorter term bonds actually pay higher interest rates than longer term bonds. For example, in late 2018, yields on 5 year notes actually fell below the yields on 2 and 3 year notes. This is an extremely rare situation and of course the pundits disagree on why it happens and what it means. There are books written on this subject.

So now the harder question about what it means for all of us average investors…

Historically an inverted yield curve has preceded many of the most recent recessionary periods (2005, 2006 and 2007) when equity markets collapsed. Not all yield inversions have led to recessions BUT when we have had recessions in the last 50 years, there was a preceding inversion in which yields on longer term Treasuries were lower than yields on shorter term Treasuries. An inverted yield curve predicts higher short term interest rates, which might mean that corporations and governments have to curb expansion because it’s just too expensive to borrow money. Consumer spending also slows because of increased borrowing costs. This lack of spending can be a precursor to recession. Historically it’s been 12-24 months after an inversion before a recession hits, if it does at all.

So now what?

No one knows what will happen a year or two from now so we continue the push to develop diversified portfolios for you and recommend healthy cash reserves so that the need to sell equities at an inopportune time is greatly reduced or eliminated. The market will go down – we just don’t know when or how much! In the meantime, the market is looking strong, so keep up the dollar cost averaging and look at those 401K statements as you send them to us!

Lori