August 20, 2019

What The Heck Is An Inverted Yield Curve?

Road Curve

Date: August 20, 2019

Author: Marty Moore, CFP®

Read time: 2 minutes

 

In a normal economic environment (if there is such a thing) long-term interest rates are higher than short term rates.  This makes sense because lenders expect to receive a higher rate of interest from those they lend to for tying up their money for a longer period of time.  So, if you buy a 30-year government bond (you are the lender, the Treasury is the borrower) you will generally receive a higher rate of interest than if you bought a 2-year government note.  Another good example would be where the interest rate you pay for a 30-year mortgage will be higher than a 15-year mortgage.

In the unusual circumstance where long-term rates fall below short-term rates, the yield curve (the spectrum of very short-term rates to very long-term rates) is said to have inverted.

So, what’s the big deal?

Up until probably 15-20 years ago, it wasn’t such a big deal.  Then it was discovered that an inverted yield curve has been an accurate predictor of a coming recession.  In fact, the last nine recessions, going back to the early 70’s, have all been preceded by an inverted yield curve.

The yield curve inverted this past Tuesday so now there is real fear of a coming recession.  In reaction, the Dow dropped 800 points on Wednesday.

Can we be sure a recession is in sight?  I don’t think the business cycle has been repealed so, yes, I do believe we will have a recession.  But when is the big question.

(Side note: The business cycle – periods of robust economic growth followed by slow growth and recession – is normal.  Indeed, many would say it is necessary within an efficiently operating market based economy.) 

I can’t tell you when the next recession will begin, and no one else can either.  While an inverted yield curve has been an accurate predictor of a looming recession it doesn’t do such a good job of telling you when it will start and end.  Sometimes recessions have occurred within a few months after an inversion.  But at other times it has been as long as two years.

And there is nothing that guarantees that the inverted yield curve pattern will continue to hold true.  The world of economics and investing are filled with past patterns that work consistently for a period of time until they didn’t any more.  In fact, if you read or watch any of the current commentary (and I would recommend only doing this in small doses) you will hear the counter argument that the inverted yield curve predictor of a recession is so well known now that there is a good chance that it may no longer be so reliable.  (Former Fed Chair Janet Yellen has spoken about this over the past few days.)

You will also hear the counter argument at this time of how strong the economy is.  And it is strong – low unemployment, low inflation, low interest rates, steady GDP growth, excellent corporate earnings, etc.

Bottom line: A slowing economy, and ultimately a recession is sure to happen at some point, but there is not enough evidence to suggest that it is imminent.  And there is no compelling reason to suggest a change in your long-term investment plan at this time.

What about that 800 point drop?

Sounds big, and it is.  But context is required and a specific number such as 800 is meaningless without knowing the percentage decline.  The 800 point drop was about a 3.0% decline.  Again, not insignificant, of course, but also not that unusual.  It’s happened 307 times since 1900.

Red = Days the Dow has been down 3% or more

Dow Jones Industrial Average
Chart by Michael Batnick, Ritholtz Wealth Management

You can see that many of the 3% declines happened in and around the great Depression, but there is also a large amount over the more recent period.  (Note October 1987 for some additional context.)

Even further context: At the beginning of 1990, the Dow was at 2,753 (Source: Dow Jones, Sec.gov).  It is now around 26,000.  That’s an average annual growth of about 8.1%, not including dividends.

Something To Think About…

You did not choose your:

  1. Birthplace
  2. Skin color
  3. Birth parents, family
  4. Birth gender
  5. Birth language
  6. Birth name
  7. Ethnicity
  8. Born abilities

You can choose to be:

  1. Kind
  2. Generous
  3. Honest
  4. Grateful
  5. Respectful
  6. Optimistic
  7. Humble
  8. Teachable
  9. Faithful
  10. Happy
  • Vala Afshar

 

As always, thanks for reading.  Have a kind, generous, honest, grateful, respectful, optimistic, humble, teachable, faithful and happy day!
Marty

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