Since the 1970s, the world has seen a yield curve inversion as one of the most reliable signals of a looming recession. One can hardly turn on the nightly news without hearing about the most current inversion of the yield curve and its far-reaching implications. Understanding what effect this may have on portfolios is a growing concern for investors.
Before panic sets in, we offer a few insights to help you gain knowledge and build confidence in the power of a long term investing horizon even as many media outlets promote knee jerk reactions.
By answering two simple questions: what does the yield curve inversion mean for capital markets, and what can be done to protect my investments, you may learn some helpful strategies to stay safe and dry in any coming storms.
It is worth saying right away that when it comes to the yield curve, there are as many opinions as there are economists.
At Pathways Financial Partners, we base our investment insight on research backed by reliable data. Though many Wall Street “gurus” may say “this time it’s different,” history of the yield curve paints a relatively consistent pattern. And in investments, we prefer consistency.
The Yield Curve
You may not know exactly what the yield curve is, or why “an inversion” is of any concern so let’s take a look.
The “curve” is just a graph that tells investors the difference between the interest rate yields on long-term bonds (a.k.a. how much an investor can expect to get paid for long-term lending) minus the interest rate yields on short-term bonds (how much an investor can expect to get paid for short-term lending).
In a healthy economy, long-term yields are expected to be higher than short-term yields. Which makes sense when you consider lending out a hundred dollars to be paid back in a week is a lot safer than lending out a hundred dollars to be paid back in 10 years. As with all graphs, however, the yield curve can change shape. And when it does there are implications to investors.
The three shapes the yield curve can take are normal, flat, and inverted.
The normal curve is what investors see in a typical economic environment, depicted in the graph below. As the time horizon for a bond gets longer, the return, or current yield, also increases.
When the difference between long-term and short-term yields narrows, the curve is said to “flatten” to represent this change.
If short-term yields should become higher than long-term yields, it is called an “inversion.” This happens when investors feel that long-term debt may return less than short term debt, often accompanied by fear of a recession in the near future. After all, why lend out a hundred dollars for ten years if you can lend out the same hundred for a week and get more money out of it?
As the curve inverts, investors demand a higher return for shorter term investments. An inverted curve looks like this:
Great, But Why Should We Care?
As an investor, should you be concerned about an inverted yield curve?
Perhaps, given the fact that since the 1950s, every time the yield curve inverts a recession has followed.
The predictive power of the inversion is so convincing that economists around the globe view the phenomenon as a reliable signal of an impending economic downturn:
Given that the yield curve inversion is such a strong indicator of a future recession, the question investors are left asking is: What can be done about it?
Well, there’s the catch.
While the inversion is reliable for predicting a recession will occur at some point in the future, there isn’t exactly a crystal ball that reveals precisely when that will occur. Recessions have started as quickly as 3 months after an inversion, to as late as three years.
Though the average time before a recession hits is about 24 months, there is no reliable way to predict when a recession may begin. Given the possibility that investors may continue to earn positive returns for years after an inversion, selling stocks once the yield curve inverts may turn into a disastrous decision.
What’s an investor to do?
Are we left, then, to simply wait for a recession and resign ourselves to the predictive power of the yield curve inversion?
A long-term investment strategy does not respond hastily or emotionally to a yield curve inversion or any other temporary economic condition. Trying to predict the short-term direction of capital markets is a fool’s errand and sound investing favors ignoring the noise from the media and embracing academic science.
Smart investors know that recessions, bear markets, and geopolitical events will come and trust that sticking to a long-term game plan is a recipe for success.
Remaining calm during the storm ensures your ship will still be sailing at the end when the rough seas subside.
Stay calm and keep your eyes on the horizon.