The inversion of the yield curve in August 2019 was the source of a major panic all over the world. The feeling of “we have been here before” caused a lot of unrest individuals, businesses, and finance experts. A month and some weeks after, people are still asking what this inversion of the yield curve could mean for them and the economy.
In this article, we take a look at the inverted yield curve and what it means for your financial decisions.
What is an Inverted Yield Curve: Causes and History
A yield curve is a curve that plots the yield on a bond across the maturity dates of the bond. A normal yield curve is an upward sloping curve, which means that the yield (y-axis) increases as the maturity date (x-axis) increases. The US Government treasury bonds form the basis for the plotting of a yield curve.
A yield is what you can expect to earn on a bond. Bonds generally have a low return rate. However, they are very popular because they are stable, with guaranteed returns. For example, there has not been a record of the United States government defaulting on any of their treasury bonds. So when you buy a bond, you are confident that you will not lose your money. This is in contrast with stocks where a significant dip in performance of the company or related industry can cause an investor to lose their investments.
Another reason why bonds are popular is that they provide incentive for long term investment. So the longer the maturity date (when you get back your original investment with the last coupon payment), the higher the yield on the bond. This direct relationship flows from the time value of money. Since money available today is more valuable than money to be received in the future (due to the inflationary effect), the longer an investor “parts” with his money, the more compensation he should receive. Therefore, a 10-year bond will be more valuable than a 2-year bond.
Inverted Yield Curve: The Exception
However, this fact that flows from a basic finance rule can get turned upside down. That is, the yield on a shorter-term bond can be higher than the yield on a longer-term bond. Following the previous example, the yield on a two-year bond can become higher than the yield on a ten-year bond.
But these are not just possible scenarios. They happen, and they have happened many times already. It is when this situation occurs that we have an inverted yield curve. Instead of an upward sloping yield curve, there is a downward-sloping yield curve. As the maturity date increases, the yield reduces. Consequently, investing your money for a longer period reduces your yield on that money, vice versa.
Causes of Inverted Yield Curve
The above situation can occur for various reasons. But one major cause is that there is a growing expectation among investors that the economy is slowing down and there might be uncertainties going forward.
Inverted yield curves occur when lots of investors prefer to purchase long term bonds. As a result, the prices of the long term bonds increase, and with an increase in prices, the yield reduces. The increase in demand for long term bonds means there is less demand for short term bonds. So the prices of short term bonds reduces, and the yield goes up.
Investors make this change when they expect significant dip or a slowing down of the economy. Therefore, they prefer to invest for the long term.
An inverted yield curve also occurs at the same time as people are losing confidence in stocks. Since people can lose all or part of their money in stocks, they sell their stocks to buy long term bonds that give them guaranteed return. They make these decisions when they are no longer confident about the ability of the stock market to grow or preserve their holdings.
Consequences of an Inverted Yield Curve
But why is this a big issue?
It is a big issue because an inverted yield curve is almost always a prelude to recession. It does not mean the recession is imminent, but most times, it means it is inevitable. There were different cycles of inverted yield curves in 2015, leading up to the recession and financial crisis of 2008-2009. It was also the same in the tech bubble burst of 2001.
Inverted Yield Curves have been a precursor to recession at seven different times. The recession might take fourteen (14) or thirty-four (34) to come full circle, but it almost always happens.
An inverted yield curve is, however, not the cause of the recession; it works more like a symptom. It shows that a recession is on the way. It indicates a loss of confidence in the market and a growing expectation of a slowdown in the economy.
In terms of consequences, the inverted yield curve means long term investors earn less. It causes a loss in the yield on bonds for long term bondholders. It also affects holders of adjustable mortgages. With adjustable mortgages, interest rates fall and rise with the short term interest rate. So, with an inverted yield curve, there is a rise in the interest rate of adjustable mortgages.
Perhaps the more significant consequence is the panic that follows from such situations. Investors and even finance professionals get thrown off balance. Like in most panic situations, there might be a rush of poor decision making.
Is it a reason to panic?
It is definitely a reason to be cautious and thoughtful. But panic might be a stretch.
There are a few things to consider in this regard.
Recession is not imminent
Experts say that it may take between 14-34 months before a recession results following an inverted yield curve. The stock market may even remain stable for eighteen months. The effect hits hardest only after 22 months (on average).
So an inverted yield curve is not a reason to be thrown into panic. It does not mean that a recession will hit in the next month or that we are on the verge of another economic collapse.
There are exceptions
In 1966 and 1998, there were cases of inverted yield curves. However, a recession did not follow. While there are many more instances where recession follows from the inverted curve, it means that there are at least times when there were exceptions.
But how do we know if this will be an exception? We don’t know for sure. But there are some points experts are making regarding this current occurrence.
The role of Quantitative Easing
One of the consequences of the crisis of 2008-2009 is that many countries had to lower interest rates significantly. Some countries currently have negative interest rates. In a global economy, the economic realities of these nations will have impacts on the US economy, vice versa. As a result, many experts believe that the inversion of the yield curve is an effect of foreign bonds that pay negative interest rates. In this view, the increase in demand for long term treasury bonds is not necessarily a result of expected economic downturn but foreign bonds paying negative interest rates.
This is a viable and convincing explanation that should put some pause to the panic ride.
Other Recession factors
Inverted yield curve is not the only indicator of a coming recession. Other factors like unemployment rate, wage growth, home starts, job quits, consumer debt, and the GDP play a role. These other factors do not indicate that a recession is on the horizon. The inverted yield curve might be the first “sign,” to be followed by a negative turn in these other factors. However, it at least shows us that our panic might be too much of a stretch.
The length of the inversion is also a crucial factor. While it is better to be cautious, it is also important to not panic. Panic can be inimical to sound decision making. The length of time of the inversion so far does not add up to the level of panic spreading globally.
How should you respond?
Does this mean you should not do anything? Far from it.
In these scenarios, caution is better than panic. Caution removes some of the emotional and apocalyptic baggage that comes with panic.
So what do you need to do given the inverted yield curves and the possibility of a recession in the future?
Review your asset allocation/portfolio
This is the time to consider if your portfolio has the necessary diversification to reduce risk and increase return. This is a normal practice that investors should cultivate. But it is times like these that you can have a second look and reevaluate. Do you have enough balance between stocks and fixed income assets? Do your fixed-income assets mature at different times or within the same timeframe?
It may also be a time to reevaluate the companies you are holding. Did you buy this stock because of the hype, or is it a company with a durable competitive advantage? Do you have enough diversification across various industries?
Ask some of these questions in the context of your overall goals. Caution allows you the opportunity to consider what your goals are even before you start evaluating and reevaluation. Panic will not give you that time. Always keep your goals in mind before making any decision.
Remember Emergency Funds
We cannot overemphasize the importance of emergency funds. It is the fund you create in the case of emergencies like job loss, medical emergency, temporary business dip, etc. An emergency funds ensure that you do not incur debt when emergencies arise.
Most people use debt to take care of emergencies, incurring the high cost of servicing debt. But with an emergency fund, you have money set apart to meet emergencies without incurring debt.
Your emergency funds should be a multiple of your monthly expenses. It may be between 3X-6X, depending on some important factors. There should be a balance between interest and liquidity when deciding where to keep your emergency funds. But as a general rule, liquidity is more important. You should not keep emergency funds where you will have to pay a penalty to access it when an emergency arises.
An emergency fund gives you more confidence going forward without the panic of a possible recession.
When it comes to personal finance decisions, caution is better than panic. Do not make rash decisions or be embroiled in a herd mentality. Carefully assess every situation and make a decision that is in keeping with your personal finance goals (which flows out of your life goals)