With this market, it’s always something.
First it was inflation. Then it was technology companies, and then North Korea and then the Federal Reserve’s policy on interest rates. And a trade war? It’s enough to make your head spin.
Prepare for more dizziness as the latest economic worry is the inverted yield curve, a suitably wonky bit of information that just sounds bad, like a dislocated elbow. In fact, it is said to be directly linked to the future health of the economy. The shape of the yield curve has been changing recently and is nearing an inversion which experts say is a condition that has existed prior to the last seven recessions.
For starters, here’s how the yield curve works. It is a plotting of the yield on government bonds by the maturity of those bonds – from those that mature in the next couple of years to those that mature in 30 years. Most of the time, the yield curve shows a healthy difference between the return you would get on a short-term bond (a two-year maturity is typically the benchmark here) and a long-term bond like a 10-year U.S. Treasury bond.
The concept is, of course, that the longer you have to commit your money in an investment, the better return you will demand (this is called the Term Premium for those keeping score at home) A normal yield curve is positively sloped reflecting increasing yields as the maturity of the bond increases.
So what causes the yield curve to flatten or invert? Here’s where economics come in. Typically a flat or inverted yield curve exists when the Federal Reserve is raising short-term interest rates (as they are now). This causes short term to rates to, well, rise. And why does the Fed raise short-term interest rates? To keep the economy from overheating and creating inflation. If investors believe that Fed will be successful in managing inflation or that rising short-term interest rates are bad for future economic growth, they will be more comfortable owning long-term treasury bonds. This will in turn drive more demand for long-term bonds and drive down long -term yields (as the price of a bond increases, its yield decreases). The combination of rising short-term rates and declining long-term rates causes the yield curve to flatten and possibly invert.
Currently, we are nearing a flat yield curve (very little difference between the yields on two-year and 10-year government bonds) and whenever that happens, investors worry that the dreaded inverted yield curve is coming.
Here are a few points about yield curves to keep you from burying your money in the backyard:
- While an inverted yield curve is accurate in predicting recessions, a flattened yield curve does not always result in an inverted yield curve. In 1994-1995, the yield curve was nearly flat, but aggressive moves by the Federal Reserve to cut short term interest rates kept the curve from inverting. And, anyone who made a bet that the economy was going to slow in the late ‘90s missed out on one of the historic stock market moves of the last century.
- Even if the yield curve inverts, there is a lag between its occurrence and a recession. Over the last five recessions since 1978, the average lag was 17 months. So this is not a tomorrow thing and many experts believe that the overall stock market has significant room to run.
- There is a lot of positive momentum in this market. Job growth is strong, inflation is low and there is good economic growth as measured by GDP. Additionally, the second quarter earnings from the nation’s largest public companies have gotten off to a great start (typically public companies release earnings within 30 or so days after quarter end).
Basically, this is turning into the market version of Gilda Radner’s old character on SNL who said “it’s always something.” So, if you want to worry, you can find a lot to worry about, but this flattening, perhaps inverting, yield curve is really something. It is relatively rare and has a good track record of predicting future economic growth.