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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.



November 2018: A False Sense of Security

October 2018: Reflections From Over Four Decades

September 2018: A Decade of Assisted Recovery

August 2018: The Entitlements Train Wreck - Possible Solutions?

July 2018: Is Wage Growth In This Country Improving Over Time?

June 2018: The Impact of Corporate Tax Reform

May 2018: Kentucky Derby Talks - Bulls vs. Bears

April 2018: How Much Longer Can Interest Rates Stay So Low?

March 2018: Policies For Economic Growth

February 2018: Volatility

January 2018: So What's In Store For 2018?

December 2017: Tax Cuts and Jobs Act: Good or Bad for Me? It Depends.

November 2017: Whack-A-Mole - D.C. Style

October 2017: Should You Consider a Robo-Advisor?

September 2017: Alternative Investments - What and Why?

August 2017: The QT Quandary

July 2017: Quality of Life Influencers (Cont'd)

June 2017: Quality of Life Influencers

May 2017: Repatriation Myths and Realities

April 2017: Time to Invest in International Equities?  Let's Take a Look...

March 2017: Valuation - A History Lesson

February 2017: The Prince of Darkness

January 2017: Mountains of Debt - Does it Matter Anymore?

December 2016: Trumponomics: Reagonomics' Twin?

November 2016: Found Money

October 2016: Marrying Theory and Practice

September 2016: Do You Have a Sharpe Portfolio?

August 2016: Be Careful of High Dividend Stock Strategies

July 2016: "Die Younger" is Not a Strategy

June 2016: Blame Tina

May 2016: Would You Rather:  Tax Cut or Tax Increase?

April 2016: Father Time Demands Your Attention

March 2016: What Has the Last Year Taught Us?

February 2016: Winners and Losers of the Oil Battle

January 2016: Diversification Improves Returns and Lowers Risk

December 2015: Synergy and the Art of Building High Performance Portfolios

November 2015: Take Control...or the Government Will For You

October 2015: A Note from Our Dean of Business

September 2015: Double Espresso at Midnight

August 2015: An Allocation to Hedge Funds - Essential!

July 2015: Another Greek Tragedy?

June 2015: What Does Financial Planning Mean To You?

May 2015: The Active vs. Passive Battle

April 2015: Out on an Island – Preparing for the Fed Rate Hikes

March 2015: To Fee or Not to Fee?

February 2015: European Central Bank Tries QE – Will it Work?

January 2015: 2014 Recap