Exploring the Bond Yield Inversion
Judith G. Alexander-Wasley MBA. CFP®
On the morning of August 14th, 2019, headlines were streaming on major news sites that the 10-year Treasury yield had fallen below the two-year note prompting the inversion of the yield curve. The media went a step further declaring the inversion as an imminent indicator of a recession. Subsequently, the Dow Jones Industrial Average sank by 800 points; the broader S&P 500 Index was down 86 points, and the NASDAQ was lower by 242 points. With memories of the market turbulence of last December still fresh in many people’s minds, the prognostication of a looming recession was not welcomed news for investors. While a yield curve inversion has occurred more than once in the recent past, this does not mean it’s time to metaphorically “run for the hills.” To understand the yield curve inversion, and why some economists use it as a predictive model for future recessions, it could be helpful to initially understand how the bond market functions in relation to current and future economic conditions.
Bonds represent the debt of companies or the U.S. Government. Investors lend the money to companies or the Government, and in exchange, receive an interest “coupon” (the annual interest rate paid on a bond, expressed as a percentage of face value) at predetermined intervals until the principal is returned to the lender on its maturity date. The maturity is typically determined when the bond is issued and can range from 1 day to 100 years; although, the majority of maturities span between 1-30 years. Since a bond’s term can span several years, they are often separated into 3 categories: short-, medium-, and long-term. Generally, bonds are considered a more conservative investment than stocks and they typically provide a steady stream of income.
The bond market is often viewed by economists as a predictor of overall economic conditions. When the economy is robust and consumer sentiment is positive, investors are likely to pull away from the slower growth of long-term bonds in favor of stocks, which may carry more risk but may generate greater returns over time. When investors view the economy less favorably, many will consider repositioning their holdings from stocks into bonds to lessen volatility. This scenario creates a supply-demand challenge as the greater demand for bonds will drive up the price of bonds and lower the yield, or return the investor reaps. The increased propensity of investors to secure bonds can foster the yield curve inversion.
A “healthy” yield curve, or one where short-term interest rates are lower than long-term, historically indicates a growing or expanding economy. In contrast, an “inverted” yield, or one where short-term rates are greater than long-term, are viewed by many as an indicator of a slowing economy or economic recession.
The Federal Reserve Bank’s Federal Open Market Committee (FOMC) typically raises rates when they see the economy as thriving to curb inflation. Their rate hikes last year may have led to some slowing in the market. Potential concerns by many investors that the ongoing trade dispute with China will bring about a recession may have led to greater stock “sell-offs” and increased purchasing of long-term bonds, prompting higher prices and lower yields.
In this past month, August 2019, the yield has inverted twice so that 2-year Treasury bonds were trading at a higher yield than 10-year bonds. These inversions only happened briefly, but many are concerned that the inversion is a signal of an oncoming recession. Over the last 50 years, a yield inversion has sometimes preceded a recession. However, it is important to note that in the past an inversion typically did not signal an immediate recession. Most occurred approximately 22-24 months following the inversion. Furthermore, the inversion does not measure the length or severity of a recession.
It could be helpful to remember that the bond market, in general, is driven by investor’s expectations for future economic growth. The trades of stocks and bonds are made by people. While different computational technologies may assist, the financial decisions of people are generally the main driving factor of the economy. People may be motivated to buy and sell based on strong emotions, such as fear. Uneasy political conditions and the possible long-term consequences of a trade war could lead investors, and companies, to favor less risky financial options, such as bonds.
By many measures, the U.S. economy is considered to be relatively healthy: with low unemployment rates, rising wages, and steady GDP growth. Predictive models, such as the inverted bond yield, often only measure one piece of the entire economy. While it could be helpful to heed possible warning signals, it may also be beneficial to consider various other factors which could affect economic conditions.
If you do have any questions regarding the financial landscape, it may be a good time to reach out to your advisor to discuss your current financial picture to make sure it is in line with your vision for the future.
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