Yield curve inversions can be a key indicator of a recession on the horizon
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Now that the Federal Reserve has raised interest rates for the first time since 2018, many in the financial media are revisiting the subject of inverted yield curves.
Because the term yield curve inversion has returned to the news, you may wonder what this is, what it portends and why it is getting so much press.
What is a yield curve inversion?
If someone borrows money from you, the length of time until they pay you back should be a determinant of how much interest you charge. The longer it will take until you are paid back, the higher interest you charge, because the risk you bear as the lender is greater. For example, a 30-year mortgage has a higher interest rate than a 15-year mortgage. That is common sense.
However, in bond markets, this yield-time relationship does not always hold true. There are rare times when long-maturity bonds sport interest rates that are lower than short-term interest rates. Yields are then said to be inverted.
What this means for investors
In simplified terms, when short-term rates are higher than long-term rates, the market is saying: “Good times are here ... but bad times are coming.” Central banks typically raise interest rates to curb inflation as the economy strengthens, but they lower interest rates to stimulate business activity when the economy is struggling.
Consider the following. As we write this at the end of May 2022, a 10-year treasury note is yielding about 2.75% while a 5-year treasury note is yielding 2.74%. Today’s relationship between 5-year and 10-year bonds is described as a flat yield curve, which could easily invert in a matter of days. Generally, when discussing an inverted yield curve, most are referring to the 10-year and 2-year treasury bonds. The 2-year and the 10-year government bonds were slightly inverted in late April. As of the time of this writing, the 2-year bond was yielding 25 basis points (0.25%) less than the 10-year bond. The next round of interest rate hikes by the Federal Open Market Committee could once again lead to an inverted curve.
Assuming investors have a long-term time horizon, what would make them buy the lower-yielding, more volatile long-term bond rather than just rolling over a series of 2-year bonds at the same rate or rolling over 5-year bonds at a higher rate?
Advantage of 10-year note
Choosing the 10-year note makes sense if an investor thinks interest rates will fall enough over the next 10 years that locking in a 2.75% long-term return would produce a result at least as good as the return with a series of short-term bonds. Typically, some kind of recessionary event would be necessary to cause short-term rates to decline. Indeed, an inverted yield curve has preceded the last seven U.S. recessions. This is why many investors are concerned.
It’s important to remember, however, that the yield curve reflects investors’ expectations for interest rates, inflation and economic growth. Investors are human, after all. There is no guarantee the market’s collective prediction will come to pass. A recession did not follow the yield curve inversion in 1966. The market experienced a recession after a brief inversion in late 2019. However, the global pandemic was the clear catalyst behind the slowing economy then. One can certainly question the predictive nature of the last inverted yield curve, given how quickly the economy rebounded once pandemic restrictions were lifted.
Concern about imminent recession
Many commentators have offered up plausible reasons why a yield curve inversion may not be indicating an imminent recession today. Among the reasons are the unemployment rate is 3.6%. Consumer spending makes up 70% of the U.S. economy, therefore we currently lack a key component of a recessionary environment.
In addition, yields today are flat (equal across bond maturities) more so than inverted. A flat yield curve is not a recessionary signal.
Also, a yield curve can remain inverted for some time before a recession occurs. Temporary inversions have had limited predictive value.
Federal Reserve Chair Jerome Powell recently disputed the predictive nature of inverted intermediate-term rates. He suggested the Federal Reserve has research indicating the first 18 months of the yield curve (comparing 30-, 60-, 90-day rates, etc.) are more effective recessionary predictors. The 90-day treasury is yielding 1.13% vs 2.75% for the 10-year note, far from an inversion.
Conclusion
Recessions are difficult to predict. Typically, the economy is in a recession for multiple months before the consensus realizes it and economists confirm it. In fact, a case can be made we are already in the midst of a recession. Financial growth in the United States (as measured by gross domestic product) declined 1.4% in the first quarter of 2022. The Standard & Poor's (S&P) 500 index declined nearly 20% from its January peak and, if Q2 data show a second quarter of declining growth, one can argue the criteria for a (very mild) recession have been met. It is important to note a modest recession is not an indicator the stock market is headed sharply lower relative to today’s levels. The market is attempting to forecast the economic environment a year from now. Slowing growth has been widely accepted and priced into stocks, which is the reason the S&P has declined by double digits year-to-date.
Unemployment is low at 3.6% and businesses are generally healthy despite feeling modest pressure on profit margins. A flat or slightly inverted yield curve will not single handedly alter the current environment. The shape of the curve could be an indicator conditions will change, but it should not be used as an infallible tool for making investment decisions.
Investing is certainly not risk-free. One can always find a reason to be concerned about the economy and equity markets. Inflation and geopolitical unrest top the list today. The shape of the yield curve is worth watching. However, we think the shape of the yield curve (today) is not a reason to alter your long-term investment strategy.
References:
Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
www.statista.com/statistics/188185/percent-change-from-preceding-period-in-real-gdp-in-the-us/
For more information:
Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon practicing at Northwestern Medicine in Warrenville, Illinois. He can be reached at sanjeevbhatia1@gmail.com or @DrBhatiaOrtho.
David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com, where Andrew Taylor, CFP, is a partner and wealth advisor. You should seek professional tax and legal advice before implementing any strategy discussed herein. They can be reached at mandell@ojmgroup.com or 877-656-4362.
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