• Hannah Boundy, CFA®, CFP®

Understanding the (Inverted) Yield Curve

Updated: Sep 2, 2019

In recent weeks, market commentary on the state of the yield curve has been substantial with many noting the history of inverted yield curves as a predictor of recession. To understand the nature of an inverted yield curve and how it might be related to a market pullback, it is beneficial to first examine what a yield curve is and how it moves.



Normal Yield Curve

Put simply, a yield curve is a graph of yields for the same type of fixed income security with varying maturities. The yield curve often quoted with regards to the health of the U.S. economy is that of U.S treasuries because treasuries are considered a safe harbor for investors given their stability and security. In a normal environment, the yield curve is upward sloping because treasuries with longer maturities typically yield more.

Inverted Yield Curve

It’s important to remember that yields are driven by demand and demand is often influenced by market perception. When market participants are anxious about the future of the economy and the likelihood of lower rates, they will try to lock in current rates on long-term securities. This shift in demand pushes yields on shorter-maturing securities higher while causing yields on longer-maturing securities to drop. The result is an inverted yield curve:


Because the yield curve typically inverts before a recession due to the behavior mentioned above, it’s often cited as a predictor of recessions:

Used with permission from Pacific Investment Management Company LLC.

It’s important to remember that while most recessions have been preceded by an inversion, not all inversions are followed by a recession. There are instances where the yield curve inverts but a recession does not follow or may follow after an elongated period of time as shown by the graph above. While the expectation of lower rates in the future can cause the yield curve to invert, there are always other variables at play and we should be careful to jump to conclusions before looking at the broader economic picture.


For instance, if domestic investors are pushing up the shorter end of the yield curve due to concerns about the local economy, we would expect the yield curve to be a stronger predictor of a murky market. But it may be that foreign investors are locking in rates on longer-term U.S. Treasuries as a result of negative rates in other parts of the world. Noted economist Mohamed El-Erian echoes this sentiment in a recent interview saying, “The bond market is distorted. It is distorted by what’s happening outside the U.S. If you live in an interconnected world, you have no choice but to import the effect of negative policy rates in Europe.” Former Fed Chairs Yellen and Greenspan have also offered similar sentiments as of late with Yellen saying, “there are a number of factors other than market expectations about the future path of interest rates that are pushing down long-term yields” and Greenspan noting, “There is international arbitrage going on in the bond market that is helping drive long-term Treasury yields lower.”


"The bond market is distorted. It is distorted by what’s happening outside the U.S. If you live in an interconnected world, you have no choice but to import the effect of negative policy rates in Europe."

When it comes to analyzing the yield curve and trying to discern between instances of true predictive values and false positives, it is beneficial to consider other variables such as measures of credit spread, central bank movement, investor sentiment, and the overall strength of the economy. As things stand today, credit spreads have yet to move in a manner that would indicate a potential near-term recession and while the economy is unlikely to continue growing at the rate it has since the last downturn, it still appears to be healthy. As Tiffany Wilding and Anmol Sinha of PIMCO put it: “Unlike the lead-up to past U.S. recessions, today’s financial stability risks appear moderate, bank balance sheets are strong, household leverage is manageable, and the personal savings rate is high. All of these fundamentals should help buffer an economic downturn.”


On the other hand, it is worth noting that we are now in the longest economic expansion in modern financial history and each day brings us that much closer to the next downturn. When the downturn will occur, it’s size, and its duration all remain unknown and trying to control for unknowns is both costly and difficult, if not impossible. In my research for this article, I came across a statement by a senior economist at Vanguard that sums up these obstacles well: “Tactical bets are always very difficult to execute successfully. Instead of adjusting your portfolio because of an expected slowdown or even recession, it makes more sense to prepare yourself mentally and cultivate the resolve not to react.” With regards to the current state of the yield curve, we want to be mindful of what’s going on but also anchored to our financial planning principals and committed to our long-term market perspectives.


“Tactical bets are always very difficult to execute successfully. Instead of adjusting your portfolio because of an expected slowdown or even recession, it makes more sense to prepare yourself mentally and cultivate the resolve not to react.”

While we don’t know where the market is headed, it’s worth noting that there is plenty of uncertainty on the horizon and potential for increased volatility as our current expansion ages. Here at Sherwood, we remain diligent in keeping up with our fund managers and their market insights and making sure that the movements they are making in their respective funds stay aligned with the objectives we hired them to pursue. We also remain committed to making sure that our clients are invested for the long-haul, taking into account both the needs of their unique financial situations and their personal preferences and tolerances for risk. If you would like to learn more about our process and beliefs, we invite you to take a look around our website or contact us for more information.


 

Belvedere, Matthew J. “Mohamed El-Erian: Inverted Yield Curve Recession Signal Is 'Distorted' This Time Around.” CNBC. CNBC, August 15, 2019. https://www.cnbc.com/2019/08/15/mohamed-el-erian-inverted-yield-curve-recession-signal-distorted.html.


Fitzgerald, Maggie. “Janet Yellen Says Yield Curve Inversion May Be False Recession Signal This Time.” CNBC. CNBC, August 14, 2019. https://www.cnbc.com/2019/08/14/janet-yellen-say-yield-curve-inversion-may-be-false-recession-signal-this-time.html.


King, Thomas B., Andrew T. Levin, and Roberto Perli. “Financial Market Perceptions of Recession Risk.” SSRN Electronic Journal, 2007. https://doi.org/10.2139/ssrn.1049081.


Patterson, Andrew. “What a Yield Curve Inversion Does and Doesn't Tell Us.” Vanguard. June 5, 2019. https://institutional.vanguard.com/VGApp/iip/site/institutional/researchcommentary/article/InvComYieldCurveInverted.


Wilding, Tiffany, and Anmol Sinha. “Yield Curve Inversion: Markets Are Correct to Price In Higher Recession Risk.” Pacific Investment Management Company LLC. PIMCO, August 19, 2019. https://blog.pimco.com/en/2019/08/yield-curve-inversion-markets-are-correct-to-price-in-higher-recession-risk.

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