The Inverted Yield Curve: Q&A with a CERTIFIED FINANCIAL PLANNER™ ProfessionalSubmitted by Reby Advisors | Certified Financial Planners | Danbury, CT on August 16th, 2019
Q&A with Patrick Doherty, CFP®, August 16, 2019
Wednesday, August 14th marked the biggest single day loss in the stock market in 2019, primarily due to alarm over the inverted yield curve – the yield on 10-Year Treasury Bonds fell below the yield on 2-Year Treasury bonds for the first time since 20071 – signaling to many investors that an economic recession may be in the not-too-distant future.
Below, you'll get answers to some frequently asked questions about inverted yield curves and the recent developments in the market. As always, please do not hesitate to call Reby Advisors at (203) 790-4949 if you have additional questions.
What is an inverted yield curve?
A yield curve is considered inverted when short-term bonds pay higher yields than long-term bonds of the same credit quality, which is atypical.
Typically, long-term bonds pay a higher yield than short-term bonds because a longer time frame brings greater risk. Bond issuers generally offer higher yields in exchange for the increased risk that investors incur when making a long-term investment.
How does an inverted yield curve happen?
The inverted yield curve occurs when short-term bonds are considered riskier than long-term bonds; the additional risk of holding short-term bonds necessitates a higher yield.
Generally, the yield curve inverts when there is widespread belief among investors that short-term interest rates will soon fall, causing bond investors to “lock in” a yield for a longer period of time. The rush to invest in long-term bonds causes the yields on those bonds to fall, because bond prices and bond yields move in opposite directions.
Why is an inverted yield curve considered a warning sign for a potential recession?
It’s important to note that an inverted yield curve does not cause a recession. It's an indicator, like a "check engine" light on a car dashboard.
The Federal Reserve often lowers short-term interest rates during recessions. The expectation of a recession brings with it the expectation that short-term interest rates will soon drop.
In other words, it's a warning sign of a recession because it's a signal that bond investors believe a recession is coming. More importantly, an inverted yield curve has been an indicator of recessions over the past 50 years2, according to Yahoo! Finance.
Does this mean a recession is imminent?
The inverted yield curve is not a guarantee of things to come, and it has been a false signal before. Reasons for optimism include strong retail sales, the possibility of Fed action and the fact that the inverted yield curve has, so far, been brief.
According to UBS:
“Bond yields signal recession risk, we say not so fast. ... Unlike trade conflicts, an inverted yield curve by itself has limited economic impact. Instead, its signal about the health of the economy is what matters, and it is not as negative as some investors fear. For one, there’s been a long and variable lag between initial inversion and the start of recessions: 22 months on average, ranging from 10 to 36 months for the last five recessions. In addition, Treasury yields are being weighed down by the almost USD 16 trillion in sovereign bonds globally with a negative yield, distorting their signal about US economic activity. Finally, the length of time the yield curve is inverted, and how much is inverted, matter. If Fed rate cuts successfully steepen the curve comfortably into positive territory, this brief curve inversion may be a premature recession signal.”3
In addition, if the underlying issues that caused the inverted yield curve to occur get resolved – such as the trade conflict with China and Federal Reserve interest rates – the current expansion may be extended.
Should I change my portfolio strategy?
If you have a strategic investment plan that is currently aligned with your risk tolerance and short- and long-term goals, then it’s almost always best to stick with that strategy. Investors typically make their biggest mistakes when they veer from a sound long-term plan.
It’s imperative that we do not allow our emotions and the desire to time the market override our sound asset allocation decision-making process.
If you currently do not have a strategy, or would like a second opinion on whether you are taking too much or too little risk, consider calling Reby Advisors at (203) 790-4949 to request a complimentary consultation.