A frequent question of late is what to make of a flattening yield curve and what action should we take?
In short – the yield curve is used as a tool which can illustrate high probability recession risk with considerable lead time of about a year and should not affect drastic portfolio decisions this early on. This is perhaps a topic not worthy of a rapidly moving news cycle but does play into the drama and thus emotions of investors.
The yield curve is simply a plot of the interest rate yields on debt instruments of different time maturities for U.S. Treasury Bonds. Most often it is an upward slope as shown below for the current yield curve, intuitively paying a higher interest the longer maturity of a bond.
The drama – The Federal Reserve is currently set to continue raising short term rates while the remainder of the slope is set by market growth and inflation expectations. If longer term growth of the U.S. economy is expected to slow, those longer rates fall, which decreases the amount paid on longer term bonds versus what shorter term bonds pay. Today, a 10 Year Treasury pays you 2.82% while a 2 Year Treasury pays you 2.54%. That’s a whopping 0.28% more interest per year while locking up funds for an additional 8 years. That’s not exactly enticing.
This thin additional interest, or spread, is the item of concern among the markets. An inverted Yield Curve, (picture 10 Year Bonds paying less than 2 Year Bonds as a downward slope) has predicted the last 7 recessions. Currently, the probability of recession in June 2019 is around 12.5% based on the yield curve.
The key operative is inverted and not just flat yield curve.
While a seemingly great tool, the stock market and the economy are said to rhyme but are not singing the same song. Markets typically bottom halfway through a recession and a merely flat yield curve is not a predictive tool for a significant -20% correction as we’ve seen 5 bear markets since 1960 without any inversion, most recently in 2011.
S&P 500 Bear Markets without Recession
There are several variables that can affect this outcome, one of which is a pause by the Fed as we have below target U.S. inflation which would contradict current telegraphed policy rates. We’re in a new era of data availability to market participants and playing a Common Knowledge game with yield curve inversion as everyone knows this phenomenon exists.
The “why” for a market correction this time around will surely be different, but the behavior of market participants will unfortunately lead some investors to repeat the same errors of previous cycles trying to get ahead of these useful tools. As mathematically based stewards of capital, it’s important to stick to empirical decision metrics that have worked navigating these factors.