Shorter-term bond yields have climbed above longer-term ones, a phenomenon known as an inverted yield curve. That tends to happen ahead of recessions. Yet economic growth remains steady and the labor market strong, stoking a debate among investors about what the signal means now.
What is a Yield Curve?
The Yield Curve is a crucial economic indicator and shows the price of borrowing money in the bond market. Historically, in a normal yield curve, long-term bonds have a higher yield than short-term bonds. This makes sense because owning a long-term bond typically coincides with more risk.
Consider a Certificate of Deposit at your local bank. The interest rate on a five-year CD is almost always higher than the rate on a one-year CD, which is higher than the rate on a 30-day CD. You don’t know whether CD rates will move higher or lower over that term, but there’s definitely more uncertainty over five years than there is over 30 days. Similarly, when you invest in bonds of longer maturity, you would expect to be compensated more for lending your money for a longer period of time.
What is an Inverted Yield Curve?
When the yield curve inverts, short-term bonds yield more than long-term bonds. In other words, imagine walking into the bank and finding out that the 30-day CD has a higher interest rate than the five-year CD!
Why does the Yield Curve invert?
In general, an inverted curve indicates that investors expect lower interest rates—and thus lower growth and inflation in the future.
The Fed exercises more direct control over short-term bonds. At the beginning of 2018, the Fed funds rate was at a range of 1.25%-1.50%. The Federal Reserve has raised rates four times (and lowered once) since then – the targeted range is currently 2.0%-2.25%.
The long-end of the curve is more complicated. It’s affected by variables such as inflationary expectations – or lack thereof, expectations for growth, a flight to quality, the Federal Reserve, and global demand due to low interest rates on global debt.
Implications of an Inverted Yield Curve: Is a Recession Coming?
People fear inverted yield curves because they tend to precede recessions. However, to say that an inverted yield curve is a market signal for an economic slowdown is imminent is an oversimplification.
Even when the yield curve provides a correct recessions warning, it doesn’t say how far away it is. Sometimes it follows the inversion within a few months. Last time it took almost two years.
The yield curve might be less reliable than its recent U.S. history suggests. It has a terrible record internationally, for instance. It flat-out hasn’t worked in Japan, also has a poor record in the U.K. and in Germany provided no advance warning of the 2008 recession, the worst since reunification.
Sector Impacts and Recent Trends of Inverted Yield Curves
Historically, an inverted yield curve can impact different sectors in different ways. For example, financial institutions might face tighter profit margins due to the increased cost of borrowing short-term funds while lending long-term.
In recent years, despite several yield curve inversions, some economies have shown resilience. The U.S. yield curve inverted briefly in 2019, but immediate economic slowdown did not follow, partly due to strong labor markets and consumer spending.
Understanding these nuances can provide a more comprehensive view of the potential implications of an inverted yield curve on the economy and investment strategies.
Preparing for an Inverted Yield Curve
We don’t recommend that you retool your portfolio just because the yield curve is not following its “normal path”. That said, we are well into the current bull market and it’s not a bad idea to revisit your portfolio. Make sure it’s well positioned and aligned with your willingness to take risk and capacity to take risk.
At Kowal Investment Group, we understand that navigating an inverted yield curve can be challenging. If you would like further information or wish to review your portfolio, please don’t hesitate to contact us. Our team of experienced financial advisors is here to help ensure your investments are well-positioned and aligned with your financial goals. Reach out to us today to schedule a consultation.
Any opinions are those of Kowal Investment Group and not necessarily those of Raymond James. This material is being provided for informational purposes only and is not a recommendation. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
