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The Message of a Yield Curve Inversion

Kevin T. Cooper, CFA®

Vice President | Head of Investment Research


Few headlines inspire a greater sense of panic among investors than those announcing a yield curve inversion. And for good reason. Yield curve inversions have preceded the last seven U.S. recessions. But is an inversion always a clear indicator of an impending downturn? With current economic indicators vacillating between signs of continued strength and systemic weakness, the inversions we’ve experienced this year warrant a closer look.

Why Inversions Happen

To understand the significance of an inversion, it helps to revisit the message of a normal, upwardly sloping yield curve. In a moderately growing economy, investors demand more compensation (i.e., higher yields) for bonds with longer maturities. Why? Because there’s more risk associated with longer timeframes, including the risk of inflation, as well as the risk that rising interest rates or a booming stock market undercut the value of a long-term fixed income investment.

When the yield curve inverts, the opposite message holds true: Investors, expecting economic growth to stagnate or slow, flee shorter-term investments and move money into longer-term, safe-haven areas of the market like government debt. This drives bond prices up (and yields down) at the long end of the yield curve, creating a downward-sloping curve. Inversions can also be driven by central banks raising short-term rates as they attempt to head off inflation.

Decoding the Messages

Normal Yield Curve Inverted Yield Curve

The economy is positioned for growth.

A recession may be looming.

The Fed is likely to raise short-term rates in an effort to keep inflation at bay.

The Fed is likely to respond to deteriorating conditions by lowering rates.

The shorter-term future is more certain than the more distant future, therefore investors demand risk and illiquidity premiums for longer-term investments.

Shorter-term risk is greater than longer-term risk, therefore investors are willing to pay more to be in longer-term, lower-risk securities.

Positive sentiment about the economy favors growth stocks and riskier assets.

The economic cycle is ready to shift from boom to bust, driving investors to safe-haven assets like long-term bonds, counter-cyclical stocks, and gold.

2019’s Inversions

For the first time since 2007 (just prior to the 2008 market crash), the 3-month to 10-year section of the U.S. Treasury yield curve became inverted in March and then again in May of this year. According to the Federal Reserve Bank of Cleveland, inversions of that section of the curve are the most predictive, having preceded each of the past seven recessions (see chart below) and offering only two false positives—an inversion in late 1966 and a “very flat” curve in late 1998.1

Data from 1/29/60 - 5/30/19

The Yield Spread is the 10-Year Treasury yield (%)minus the 3-Month Treasury yield (%). 

Why This Time Might be Different

Some see this year’s inversions as an exception to the rule since they appear to be caused by Fed action rather than market forces. The 2019 inversions were influenced by expectations for Fed rate increases, which drove short-term yields higher. Longer-term treasury yields were largely unaffected. In their article on why the yield curve has lost some of its power as a gauge of recession, Bank of America economists Ethan Harris and Aditya Bhave observe that the Fed has the power to “prevent or quickly undo” an inversion.2 That said, while the Fed may lower the federal funds rate to undo an inversion, that may not be enough to assuage market fears. On the one hand, we appear to be in a “Goldilocks” economy that is neither too hot, nor too cold, with growth, unemployment and inflation remaining under control.3 But all that could be quickly overshadowed by the global ripple effects of a trade war.

Talking to Clients

With recent yield curve inversions in the news, some of your clients may ask for your view on the subject. While it’s a good idea to keep an eye on the economy, it’s also a losing game to try to time the next recession. To do that, you’d need to know not only when to move to cash, but also when to get back into stocks. In addition, when yield curve inversions have preceded recessions in the past, there has typically been a one- to two-year lag before a recession took place. In the months in between, the stock market often performed robustly. Sitting on cash could be a costly waiting game.

A better approach is to use the topic of yield curve inversions to remind clients of the importance of keeping portfolios up to date. We’ve just had a 10-year bull market. Are their portfolios still balanced? Now is a good time to take the following steps to prepare for an eventual end to the current expansion cycle:

  • Rebalance assets to match your client’s risk tolerance and stage in the wealth lifecycle.
  • Manage portfolios for tax efficiency.
  • Ratchet back risk where appropriate, but at the margin. Don’t be tempted to go to cash in an effort to time the market.
  • Discuss options for reducing volatility through alternative investments and high-quality long-term bond funds.
  • Steer clients away from benchmarking, which can lead to chasing performance and a herd mentality. Instead, help them focus on progress toward their personal financial and life goals.
  • Insert discussions about risk preparedness in each client conversation. See our blog The Right Way to Communicate in a Crisis for ideas.

 

Conclusion

This year’s yield curve inversions may or may not result in a recession in the next year. But they do provide a valuable reminder that a recession will come at some point in the future. The best time to prepare clients for a market downturn is before it happens. Recent yield curve inversions provide an opportunity to discuss portfolio changes that will enable you to add value to the relationship and help your clients feel better prepared for whatever the future may hold.

 

1William Watts. “The yield curve inverted—here are 5 things investors need to know.” MarketWatch. March 30, 2019.
2Vivien Lou Chen. “Inverted Yield Curve Is Waning a Recession Gauge, BofA Says.” Bloomberg. April 19, 2019.
3Kimberly Amadeo. “How is the US Economy Doing?” TheBalance.com. June 7, 2019.    


There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long term, especially during periods of downturns in the market.

WRITTEN BY

Kevin T. Cooper, CFA®

Vice President | Head of Investment Research

PUBLISHED: June 27, 2019

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