Over the last week, financial news outlets have been spending a great deal of time talking about the yield curve. So, after seeing this on every major financial news channel, I wanted to break down why the yield curve is important and what it means. The yield curve, in its simplest form, is the comparison between a long and short term bonds issued by the government. The most commonly compared are the 3 month and 10 year bonds. Just this week, according to the Treasury Dept., (data pictured above) the two bonds crossed. From an investment timeline perspective, there is now a higher return for investing in a short-term bond versus a longer-term bond. The 3 month yield is at 2.37 vs the 10 year of 2.25. Now, this might not be the most exciting news, but it is a signal that investors, or at least the bond market, are favoring short term positions.
In a great article in the New York Times, Matt Phillips and Steve Grosser break down why longer term bonds should have higher yields than short term bonds. “In an economically rational world, investors would demand higher interest rates on long-term bonds than they do for short-term ones. The reason: Locking up their money for a longer period is usually riskier and investors get paid more for that risk.” Now that’s pretty straight forward, right? The longer you invest your money, the higher the return should be.
Now you might be saying, big whoop. Not exactly real page turning stuff John! What does this stuff me for me? Well, the change in yield positions is not as important as what it means to the market. As with most things in the economy, there are broader implications than just your individual 401K’s. According to Investopedia, “When long-term rates are lower than short-term rates, the yield curve is “inverted,” which is a signal that has preceded recessions in the past with remarkable accuracy”. So that’s it, time to run for the hills! The yield curve has inverted prior to all major recessions. The New York Fed even has a yield spread calculation with probability of a recession on its webpage (website listed below). With a yield curve this far negative, the probability of a market downturn is 20%.
The silver lining here is, there is still time to make preparations for a market correction. Most sources say it could be a few months, to almost a year before a downturn in the market occurs. The question then becomes, do we become active participants in our own finances and proactively manage out investments? Or will we try and grind out every last % of gain (alpha) we can and hope for the best?
Reference Material
https://www.newyorkfed.org/research/capital_markets/ycfaq.html
https://www.investopedia.com/time-to-worry-about-yield-curve-inversions-4688662
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