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A Yield Curve Primer – The Real Reason Why An Inverted Curve Matters

A Yield Curve Primer – The Real Reason Why An Inverted Curve Matters

what is a yield curve

It’s normally possible to read about personal finance without excessive worry about economics. Markets go up and down while the cacophony of economic noise blares ever presently in the background. Sometimes, however, with all of the subtlety of a drunken Doordash driver plowing his old ass Chevy Cruze into your living room, economics suddenly matters and warrants contemplation. The inverted yield curve of 2019 is one such event.

Recent movements in financial markets related to the impasse in trade negotiations with China have sent yield curve spreads to new cycle lows, a rather ominous sign for economic growth and forward equity returns. This post is a crash course on what the yield curve is, what an inverted curve means, and why you should care.

What Is An Inverted Yield Curve?

The yield curve should be intuitive enough to anyone who ever shopped for certificates of deposit or noted that a 15 year mortgage rate is lower than a 30 year rate. During normal times, investors require a higher yield to invest in securities of longer duration to compensate them for the lack of liquidity. The relationship between time and interest rate for US government bonds is generally referred to as “THE” yield curve.

From time to time, a very weird phenomenon transpires. Instead of requiring greater interest rates for longer durations, long-term interest rates fall UNDER short term rates. This is known as an inverted yield curve, and it’s not good:

inverted yield curve

Yield Curves And Economic Growth

An inverted yield curve has a particularly spine-tingling connotation to all economists because it is overwhelmingly associated with an impending recession. Rather than looking at the constant shape of the curve, it is exceedingly common to look at the difference between a short-term rate (3 months) and a longer-term rate (10 years).

This spread, the 10-year/3-month spread is so commonly followed that the St. Louis Fed tracks its values while the Cleveland Fed uses it to forecast recession probabilities. Negative values of this spread nearly tautologically imply a recession in the subsequent 6 to 24 months:

The exact mechanism for why this leading indicator works is not entirely clear; it may be reflective that the Fed (which controls extremely short duration interest rates) committed a policy mistake by leaving monetary policy too restrained. It may reflect investors flocking to long dated bonds and pushing yields lower as they try to avoid getting excrement on them from the shit hitting the fan as things unfold. Or both. Whatever the cause, it is at a minimum a cause for caution and to re-assess investment philosophy and/or risk allocation.

Using historical data for the last 60 years, an inverted 10 year/Fed Funds Rate (a close proxy for the 3 month) resulted in a recession 7 of 9 times, with an average lead time of 14 months.

inverted yield curve to recession

Recessions Are Dynamic Events

I tend to view recessions as probabilistic events. As throwing rocks into a snow-covered mountainside may work out just dandy 9 times out of 10, there exists a chance that any given throw might result in an avalanche. An inverted yield curve and an economic expansion a decade old suggests the risks are somewhat higher than normal. The Cleveland Fed would agree with this assessment, their estimate for a recession in the next 12 months as of May will almost assuredly be in the 40% range.

That is not to say that a recession is imminent or unavoidable. The global macroeconomy is an interplay of an innumerable number of individuals conducting trillions of transactions, each with their own subtleties and lag times in responding to incentives. The dynamism of the whole thing means that firms and individuals are constantly altering their current behavior in response to what they observe and feel.

My belief is recessions are somewhat self-fulfilling in this regard. Somewhere sitting in boardrooms around the country finished with rich mahogany, C-level executives are grappling with uncertainty about rising labor costs, trade uncertainty, and a nasty economic environment portended by the yield curve. Is it a stretch to think they might dial back plans for expansion or hiring as a result?

If enough of them believe this, recession follows.

Equity Returns After Yield Curve Inversions

Why does any of this matter?

If inverted yield curves are associated with recessions, and recessions are associated with absolute dogshit performance in equities, then it stands to reason there would be a reasonably intact relationship between the yield curve and intermediate term equities. History bears this out, as inverted yield curves are typically associated with negative equity returns (sometimes drastically so):

10 year equity returns with yield curve

Going even further, it turns out that one can project rather accurately long-term returns using only measurements of market valuation and the yield curve.

See Also

The TLDR version: equities generally fare poorly in the subsequent 3 years after a yield inversion.

Is It Different This Time?

Very possibly. Though I would obviously make a shit ton more money blogging if I claimed to know the future, I do not. I do believe it is worth noting that an inversion was handily disregarded as “this time it’s different!” at length both in 2000 and 2006.

My favorite is Wharton who claimed the yield curve was meaningless in 2006 because “there aren’t any real excesses in the economy at the current time”. How’d that one work out, guys?

Just in case you forgot..the 2000 and 2007 recessions caused total peak to trough stock losses in excess of 50%.

The Yield Curve And You

While it’s easy to calmly sit around with your net worth Excel sheet and do a “Multiply Portfolio by 0.5” exercise, for those of you not old enough to recall a recession, it’s not the wealth hit that causes the panic.

It’s when HR shows up with law enforcement and a bunch of cardboard boxes and starts telling people to pack up their shit. And the empty chairs at work and the moving vans at your neighbors as they try to downsize. It’s the latent panic in everyone’s hearts because THEY KNOW the job they’ve been bitching about on Twitter for the past 3 years is now their sole lifeline, like a piece of shitty flotsam in a hurricane, and they’ll cling to it until their knuckles turn white because there is no place to go if they get shitcanned.

Imagine that, and then consider losing 60% of your assets as the ultimate swift kick to the nuts on top of injury.

If that unnerves you, then perhaps maybe now is a good time to reflect on whether your risk level is appropriate. The world’s best estate planning won’t matter if you didn’t consider a possible downside scenario.

This article was expertly crafted by the author of Fat Tailed And Happy for The Money Mix.

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