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Ask DWM: What is an Inverted Yield Curve and What Does it Mean to Me?

Written by Lester Detterbeck.

inverted_yield_curve.jpg

 

Great question. Historically, an “inverted yield curve” has been a signal that recession was on the way. As with so many things these days, though, the old “rule of thumb” may not apply. Here’s why:

A yield curve is a graph showing interest rates paid by bonds. The chart is set up with the horizontal axis representing the borrowing period (or “time”) and the vertical axis representing the payments (or “yield”).   We all would typically expect that loans over a longer period time would have a higher interest. That’s “normal.”  For example, if a 30 year mortgage rate is 4%, a 15 year mortgage rate might be at 3.25%.   A one year Certificate of Deposit might earn 1% or less and a 5 year C.D. might be 2%. The situation is referred to as a “normal” or “positive” yield curve in that interest rates are higher as the borrowing period gets longer and the curve slopes upward, see below:

Normal

 

However, rates don’t always work that way. At the end of last week, the three-month Treasury bills’ yield 2.46% was higher than the yield (2.44%) for 10-year treasuries. This situation technically produced an inverted yield curve, since a shorter period had a higher rate. This also happened three months ago. Historically, “curve inversions” have tended to precede major economic slowdowns by about a year.

inverted

 

Inverted yield curves are unusual because they indicate lenders (or investors) are willing to earn less interest on longer loans. This is most likely to happen when the economy is perceived to be slowing down and faces a meaningful risk of recession. Historically, curve inversions have occurred about a year before the each of past seven recessions in the last five decades, though a recession doesn’t necessarily occur every time we see a yield curve inversion.

The U.S. economy has slowed already from the average growth rate of 2018; mainly as a result of the 35-day government shutdown and reaction to the Federal Reserve’s (“Fed”) reports of slower growth and a moratorium on interest rate hikes. Some economists feel the economy may slow even more due to the tax-cut stimulus being only a one year spike, headwinds from trade tensions with China, political uncertainties and global polarization and fragmentation.

However, other factors point to strong economic growth. We do have a solid labor market which drives consumption. Average monthly job creation is well above what might have been expected this late in the business cycle. Further, more workers have been attracted back into the labor force and wage growth has been 3%; a rate in excess of inflation. Business investment should rise and government spending is higher.

In short, an inverted yield curve is not a perfect predictor of recessions. A different portion of the yield curve inverted three months ago in December and the markets in early 2019 have rebounded sharply as fears subsided. Also, many economists believe the drop in 10-year Treasury yields is due to non-U.S. economic headwinds, like Brexit as well as the unwinding of the Fed’s balance sheet after Quantitative Easing. They believe it’s not because of serious weakening of U.S. economic fundamentals.

The current inverted yield curve may or may not be the bellwether of a coming recession. These days, there is not a simple cause and effect relationship between an inverted yield curve and recession. More likely will be the resolution or non-resolution of uncertainties such as Brexit, trade tensions, political matters and global peace. Stay tuned and stay invested for the long-term.

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