The Inverted Yield Curve

With all the buzz in the news on the “inverted yield curve”, we have put together a helpful primer on what this means for the economy and the stock market.

One way to think about the yield curve is that the longer end of the curve (i.e. the interest rate paid on 10-year bonds) incorporates expectations regarding the direction of future interest rates. When the interest rate on 10-year bonds is lower than that paid on 2-year bonds (which is abnormal because you expect lenders who are locked in for longer to be compensated with a higher interest rate, hence the term “inversion”), the implication from the market is that interest rates will be going lower in the future. Based on recent comments from the Fed, this is likely a fair assumption.

The reason a yield curve inversion had predated recessions past is because, in those instances, financial conditions (plainly, the “availability of money”) had been tightened in an effort to limit inflationary pressures, leading to the unintended consequence of choking off economic growth and subsequent economic decline (i.e. a recession). In those cases, high levels of interest rates needed to be lowered so that money would become more widely available to borrow (or alternatively, a more widely available money supply reduced the cost of money and caused interest rates to go lower, but that’s neither here nor there).

Could this time be different? Sure it could! Currently, financial conditions are about as loose as they could be, according to the Chicago Fed National Financial Conditions Index. The Fed has already shown a willingness to cut rates in order to sustain a “lower for longer” economic expansion. In this case, lower interest rates to come would not be because the Fed has already choked off economic growth (they haven’t). Instead, the Fed appears to be trying to sustain public confidence that it will support continued growth.

Now, could this time be like the other times and we see a recession in the next 15 months? Sure it could! Recessions happen. But it is important to note that an inverted yield curve does not cause a recession. No one thing usually does. But, there are plenty of things that can go wrong in the world, and that’s why we try to allocate our portfolios to protect against the unknown.

Stocks are likely to continue to be volatile for the next few months. Importantly, we have not seen a change in any of our Three Dials yet this month that would indicate we need to reduce stock exposure.  If we do, rest assured that we will communicate any recommended portfolio changes accordingly.

More importantly, despite any tactical changes we may make at the margins, nothing has changed in how we view investing for the long-term.

Sources:

https://www.chicagofed.org/publications/nfci/index