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Everything you've always wanted to know about inverted yields but were afraid to ask

| August 25, 2019
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Headlines, headlines and more headlines.  Since late Spring it seems we have been writing about market reactions to news headlines versus actual economics.  While market fundamentals, especially consumer related data, have remained robust for much of the 2019 trading year, stock and bond market volatility has been driven primarily by the onslaught of headline news.  Headlines have always had some impact on market direction, but that was usually coupled with a healthy dose of economic data.  Economic data plus headline news typically form the basis for market sentiment.  This year more than ever, it seems that economics are taking a back seat and that headlines are almost the exclusive driver of market direction.

News on China and trade talks; the Federal Reserve and interest rates; Brexit and European politics; or assorted tweets have all had the ability to send the market reaching for new heights or, more recently, plunging in some of the worst trading days we have seen for the year. 

While some of the headlines have a “they said—we said” quality to them, a more recent news headline that we believe is worth a deeper dive deals with the inverted bond yield curve.  The inverted yield curve has been the subject of many reports and has caused much angst over current and future market performance.  While the term “inverted yield curve” is not one that is usually thrown around in everyday conversation, it is certainly worth understanding.  So, what is an inverted yield curve, and more importantly what does it tell us?

First, let’s clarify how interest rates usually work.  Most of us understand that if we agree to pay off a loan in 2 years, our bank will charge us a lower interest rate than if we agree to pay it off in 10.  For banks and lenders, the more time a borrower has to pay back a loan, the more likely something is to go wrong.  That’s why banks want a higher interest rate for the longer-term loans, to reflect that extra risk that comes with time.

When things are inverted, they are upside-down, or backwards—they aren’t the way they are supposed to be (unless you’re baking a pineapple upside-down cake!)  When the yield curve is inverted, banks charge a higher interest rate on shorter-term loans, and investors accept lower rates on longer-term loans. 

So what, exactly, is this inversion telling us?  The over-simplified answer is that long-term investors are willing to exchange (or forego) returns for the benefit of safety.  Another way of thinking about it is that investors are expecting interest rates to fall in the future, perhaps because they expect a recession in the future.  The basic rational for this type of investment behavior is “playing defense” against market uncertainty. 

Does an inverted curve happen often?  No, inverted yield curves are rare.  And here is the kicker: when it does happen (2007 was the last time), an economic recession often follows.  But don’t hit the panic button just yet.  Over the last 6+ times the yield curve has inverted, it took anywhere from 18 to 24 months for a recession to be recognized.  Since a recession is typically recognized after two consecutive quarters of economic decline, as reflected by gross domestic product or GDP, it is worth noting that GDP is currently positive. 

We are not trying to make light of the significance of an inverted curve.  We are simply trying to educate and comment on our current economic situation.  With that said, we have solid economic data, led by a strong US consumer.  We have an accommodative Fed, which is in the process of actively cutting interest rates.  Those two things alone are not usually a recipe for a recession.  The biggest economic concern we have is the slowing of global growth.  China and Europe certainly have economic headwinds.  We will see how long it takes those headwinds to reach the US.  As we have previously discussed, we are currently experiencing the longest economic expansion in US history.  One could simply argue that we are due some type of slowdown, be it a recession or not. 

We hope this primer has helped a little to give you some perspective on the curve inversion and the possibility of a recession.  And while negative headlines get everyone’s attention and fuel market volatility, we wanted to point out that historically it has taken time for these factors and influences to take shape.

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