FAQ: The yield curve is inverted. Should I be worried about a recession?
Answer: The yield curve inversion has been all over the financial news of late. It is creating a worried environment where many are questioning the health of the economy going forward. However, maybe it’s not something you should let affect your investment strategy. Let’s see why.
What is an Inverted Yield Curve?
Inverted Yield Curve Definition – The yield curve is a measure of interest rates based on the duration of the bond you are measuring. Think of it in terms of your own savings. If you were to purchase a 3-month CD from the bank, you would expect the interest rate on that CD to be lower than the same CD with a 2-year time horizon. The interest on the 2-year CD would be lower than that of the 5-year CD, and so on. You may see the yields on bank CDs to look something like this:
3- mo.: .52%
The longer you lock up your money, the higher the return (yield) on that money. This is typically what we would consider a standard, or forward yield curve. Yields slope higher over time. In a reverse yield curve, you are not being rewarded for locking up your money for long. In fact, the longer the duration of the CD, the lower the yield. Yields slope lower over time.
The example above is what we see with Treasury Bills, Notes, and Bonds. The reasoning behind the flattening of the yield curve is that investors are expecting a weaker economy over time and would prefer to lock in safety for a longer period. Typically, during a weak economy, the demand for safe assets, such as Treasury debt, rises and thus, the yield falls. If you are expecting this type of circumstance, the longer the duration of the bond you own, the greater the return.
Does an Inverted Yield Curve Predict Recession?
During a period when the yield curve becomes inverted, you will hear a lot of investors talking about a recession, slowing economy on the horizon, and how to make safe bets on their investments. Historically, a recession has always been preceded by an inverted yield curve. However, an inverted yield curve hasn’t always meant that a recession would follow. Think about a cough; every time you have a cold you will have a cough, but that doesn’t mean every time you have a cough, you are sick with a cold. The recession is the cold. The invested yield curve is the cough.
We have recently seen the yield curve invert and it is certainly a sign that a recession may be on the horizon, but no guarantee. If you are concerned about a recession, perhaps moving your portfolio to a more conservative allocation may be a good idea; but be prepared to be wrong. Predicting economic slowdowns and stock market price gyrations can be very humbling.