August 2018 Monthly Insight: Don’t Fear the Yield Curve

Posted By T. Lee Sherbakoff, CPA/PFS, CFP® on Aug 6, 2018

“A flat yield curve, or even an inverted one, should not be on top of our worry list under today’s accommodative monetary conditions,” –Burton Malkiel, Princeton professor of economics and author of “A Random Walk Down Wall Street”, July 31, 2018

Recently you have probably heard or watched business television network entertainers, such as those on CNBC or Bloomberg Television, pontificate about a flattening yield curve and how that means we must be heading toward a recession and deep corrections in the market.  And, it’s true, over the last 50 years an inverted yield curve has been a predictor of future recessions and bear markets in stocks.  But, let’s step back and look at the fixed income sector and a flattening yield curve as nearly all our clients have an allocation to the fixed income sector.  The fixed income sector includes bonds and other credit instruments and is made up of corporate and government debt.

Most fixed income investors watch the “yield curve” and examine the yields that short-term bonds offer versus the yields longer term bonds are offering.  The yield curve is expressed by showing each available yield at each maturity period.  The “spread,” which is the yield difference between the short-term yield and the long-term yield, is what most economists focus on. The most tracked spread is the yield spread between the 2-year Treasury note and the 10-year Treasury bond.  Today, that spread is approximately 0.30% and down from September’s spread of 0.80% and 0.95% a year ago.

You might have seen or heard that economists and bankers are concerned the yield curve is flattening and perhaps may even invert.  The chart below shows the flattening of the yield curve since December 31, 2013:

For the yield curve to invert, long-term bonds must be paying less than short-term bonds.  If that is the case, it means investors in long bonds have no expectation of being compensated for tying up their money in longer term bonds, unless, perhaps, they feel that longer terms rates will fall still more in the future adding value to their longer term bonds.  Otherwise, why would they buy a 10-year bond earning less interest than a 2-year bond? Generally, a long-term bond purchaser expects to receive a term premium (higher interest rate) over shorter term bonds.

Another interesting point is that an inverted yield curve has accurately reflected investor sentiment on the economy.  The last seven recessions have each occurred after an inversion in the yield curve, although the recessions have lagged behind the inversion by 3 to 24 months.  An inverted yield curve may indicate that inflation expectations are low, businesses are not raising prices due to a lack of demand, and workers are not seeing growing paychecks.  In addition, banks are paying out higher short term interest on deposits than they are earning on long term loans.  That is unsustainable for a bank. Thus, the theory that an inverted yield curve may forecast a future recession.

It is true an inverted yield curve is typically not good for the markets or the economy.  Unfortunately, however, no one can time the market with any consistency and certainly no one can time the market by simply watching and waiting for a flattening yield curve to invert.  Although inverted yield curves have correctly forecasted economic recessions, there have been significant lags between the inversion and market corrections.  As well, we have experienced market corrections with a rising or typical yield curve.

Further, should one try to time the market by exiting the market upon an inversion of the yield curve, the investor misses out on any growth prior to market corrections and must make a near perfect decision on when to re-enter the market in order to fully participate in the market recovery.  No one can consistently mitigate re-entry risk.  Most often they miss the bottom and it costs them money.

By the way, it is true that there have been seven recessions since 1970. However, if you had invested $100 on January 2, 1970, your $100 would have bought 1.08 shares at $92.06 per share. Then if you simply had done nothing through all the market gyrations—recessions and expansions—your balance now would be just over $3,000 (2,816.29 per share).  And, had you reinvested your dividends over that same time frame, your account balance would now have just over 4.52 shares and would be worth around $12,700. Amazing.

We hope you’ve found this review to be educational and helpful. If you have any concerns or questions, let us say this one more time–please feel free to reach out to us. That’s what we’re here for.

As always, we are honored and humbled you have given us the opportunity to serve as your financial advisor.