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What the hell is an inverted yield curve and why should we care?

In the news over the last week you may have heard mention of an inverted yield curve and the rising fear of a US recession. The very term “inverted yield curve” is likely to have caused your eyes to glaze over, but in this article we break down what it is and whether or not you should buy into the fear.

What is a yield curve?

A yield curve is a line that shows the interest rates, at a certain point in time of bonds with equal credit quality, with varying terms of maturity.  The most commonly referred to yield curve is that of US Treasury Bonds. This curve shows the yields on Treasury Bonds with terms ranging from 1 month to 30 years.

Typically, the yield curve shapes upward as investors receive a premium (higher interest rate) for longer duration bonds due to factors such as liquidity risk, interest rate risk and inflation risk. This means, that the yield on 10- and 30-year Treasuries should be higher than the yield on 2- and 5-year Treasuries.

So what is an inverted yield curve and why is everyone so concerned?

The recent inversion that has attracted the most media attention is that between the 2- and 10-year treasuries. This means, that last week the rate paid on the 2-year treasury was greater than that of the 10-year treasury. This inversion indicates that investors are concerned about the short-term economic future and placing their capital into longer duration bonds. The increase in demand drives up bond prices and therefore decreases the yield. One question often posed by investors is whether inverted yield curves predict a future stock market decline. While the handful of instances of curve inversions in the US may concern investors, the small number of examples makes it difficult to determine a strong connection, and evidence from around the world suggests investors should not extrapolate from the US experience.

Is an inverted yield curve really a good predictor of an upcoming downturn?

The inversion prior to the 2008 financial crisis is interesting to review. The US yield curve inverted in December 2005, after which the S&P 500 Index posted a positive 12-month return. The yield curve’s slope became positive again in June 2007, well prior to the market’s major downturn from October 2007 through February 2009. If an investor had interpreted the inversion as a sign of an imminent market decline, being out of stocks during the inverted period could have resulted in missing out on stock market gains. And if the same investor bought additional stock once the curve’s slope became positive, they would also have been exposed to the stock market weakness that followed

Attempting to time the market is fraught with danger

Whether it be using the yield curve or another indicator, the lure of trying to time the market may tempt even long-term investors. But outguessing markets isn’t as straightforward as it sounds. Attempting to make investment decisions at exactly the “right” time presents investors with substantial challenges. First and foremost, markets are fiercely competitive and adept at processing information. Trying to time the market based on an article from this morning’s newspaper or a segment from financial television? It’s likely that information is already reflected in prices by the time an investor can react to it.

Final Word

Evidence is certainly not conclusive when it comes to an inverted yield curve being a reliable indicator of a market downturn.  The positive news is that by developing and sticking to a long-term plan that is in line with their risk tolerance, investors may be better able to look past short-term noise and focus on investing in a systematic way that will help meet long-term goals.

Disclaimer: The content of this article is general in nature and is presented for informative purposes. It is not intended to constitute financial advice, whether general or personal nor is it intended to imply any recommendation or opinion about a financial product. It does not take into consideration your personal situation and may not be relevant to circumstances. Before taking any action, consider your own particular circumstances and seek professional advice. This content is protected by copyright laws and various other intellectual property laws. It is not to be modified, reproduced or republished without prior written consent.