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The Inverted Yield Curve - In Layman's Terms Join our Monthly Newsletter December 2018

Mark R. Hoffman

CEO, Principal

As the talking heads continue to search for the specific causes of increased equity market volatility this quarter, one thing we are hearing a lot is “The Inverted Yield Curve.” But what exactly is it? How does it happen? And how much should you care?

In normal markets, longer duration bonds (e.g., 10-year U.S. Treasuries) have higher interest rates than shorter ones (2-year Treasuries). Completely logical, as tying up money for longer periods of time demands compensation for lost liquidity. But at times, the relationship flips, and shorter duration bonds have higher yields than longer ones. That is called an Inverted Yield Curve. How does that happen?

When investors fear that other investment alternatives – like the U.S. stock market – are due for a decline, many will increase investments in longer-term Treasuries. They would rather lock in a nominally positive rate of return than put their money in riskier assets. As demand for these long-term Treasuries increases, the price goes up. Economics 101. As those prices go up, the yields fall. At the same time, fewer investors tend to buy short-term Treasuries, so those rates rise. Voila – an inverted yield curve.

Why does this matter? Because an inverted yield curve is generally a signal that a recession is coming. In fact, every recession since World War II was preceded by higher yields on the 2-year Treasury than the 10-year Treasury. Every one. So, should we all panic? Slow down there, cowboy.

First, this recovering economy and bull market has raged on for a decade. There are few things that we know with 100% certainty, but one of them is that there will be another recession at some point. I don’t need an inverted yield curve to tell me that. Second, even though the 2-year and the 5-year Treasuries have actually inverted, the 2’s and 10’s haven’t. Third, even if you are sure something is coming, investing (or uninvesting) early, can be just as damaging as doing nothing. Have a look at the chart below:

Two things jump out at me. 1) Yes, historically, an inverted curve has preceded a recession. But the recession is far from an immediate reaction. In fact, recessions have begun, on average, 19 months following inversion. 2) While recessions haven’t been good for equities (to say the least), average returns for the S&P 500 following inversion have been ~21% before the recession set in. Staggering data.

In summary, no one likes a recession, and inverted yield curves have preceded each of the last seven. But the 2- and 10-year Treasuries haven’t inverted yet, and hitting the “sell all” button when it does has typically been a mistake. Our advice is to adopt a proven investment discipline, and follow that discipline until something breaks. That discipline includes prudent diversification in non-correlated assets.

Mark is a co-founder of Lanier Asset Management and serves as its Chief Executive Officer. Prior to founding Lanier, he was a partner at The Boston Consulting Group. Mark is an honors graduate of The University of North Carolina at Chapel Hill with a BA in Economics, and holds an MBA from The Harvard Business School.