What is the yield curve, and should you be worrying about it?

Christina Gayton

“The #1 predictor of economic recessions” has been inverted for a full month now.

WHAT IS THE YIELD CURVE

The yield curve, as shown in the example above, is a graph that plots the relationship between interest rate yields and time lengths, specifically for bonds. In the graph above, you can see that there is a higher return for the longer lengths of time.

This is the way the yield curve is “supposed” to look in a healthy economy; higher returns are correlated with a longer time to maturity. This is because interest rates are higher for riskier investments, and by investing money into a bond for a longer period of time, there is more risk for what could happen during that time period.

An inverted yield curve is the opposite: higher returns are given for shorter periods of time. AKA: short-term interest rates are higher than long-term interest rates. This indicates that there is a looming risk in the short term.

Thus, the inverted yield curve has been touted as a predictor of recessions.

HOW HAS IT PERFORMED IN THE PAST

Image Credit: JP Morgan

For the 2008 recession, the yield curve inverted 17 months prior.

For the early 2000’s recession, the yield curve inverted 12 months prior.

In 1998, the yield curve inverted, but went back to normal, and then nothing happened till after it inverted again in 2000.

For the 1990’s recession, the yield curve inverted 18 months prior.

For the 1980 recession, the yield curve inverted 9 months prior.

For the 1979 recession, the yield curve inverted 16 months prior.

For the 1973 recession, the yield curve inverted 7 months prior.

For the 1970 recession, the yield curve inverted 19 months prior.

In 1966, the yield curve inverted, but nothing happened until after it inverted again in 1968.

These suggest a correlation, but no direct relationship.

WHAT THE YIELD CURVE LOOKS LIKE IN 2019

The yield curve for U.S. bonds, specifically between 2-year and 5-year bonds, inverted on December 3, 2018.

Below 0 indicates inversion. Source: Financial Times.

As of yesterday, July 3, 2019, the yield curve has been inverted for a full month. The 10-year bond yields rest below 3-month bond yields by almost 30 basis points.

SHOULD WE BE WORRIED?

Yes. Yield curves, more often than not, predict a recession. It just doesn’t tell exactly when.

However, although the yield curve has been a fairly accurate predictor in the past, it is important to look at the factors that are causing the yield curve to invert.

One possible reason for inversion is that the Fed have kept short-term yield rates artificially low for years. Thus, the short-term yield rates are now just at a normal rate, not a high rate that would indicate short-term risk.

Another potential reason for the inverting yield curve is consumer worry regarding lower yields abroad, such as in Europe and Japan, and the fact that the U.S. is in an abnormally long expansion period (“A recession happens every ten years!”).

However, there are plenty of economists that see a recession as imminent, as the yield curve impacts consumer confidence and may act as a self-fulfilling prophecy.

THE BOTTOM LINE

Talk of recession has been around since 2014, and if you held off on investing in the stock market from that point to the present, you would have missed out on over 7000 points of gains.

The yield curve is marginally important. At the very least, it should never be ignored. Consider why the yield curve may be inverting and if those reasons warrant worry for a recession. To analyze those reasons, it’s worthwhile to consider the traditional factors comprising the economy: unemployment, underemployment, initial jobless claims, the housing market, retail sales, wage growth, and global and national economy growth rates.

DOW 10 year chart. Source: Macrotrends

Regardless of your belief on the yield curve however, nonprofessional traders won’t have much luck timing the market. Talk of recession has been around since 2014, and if you held off on investing in the stock market from that point to the present, you would have missed out on over 7000 points of gains. Investing for the long-term is the safest bet, but if you want to follow the wisdom of the yield curve, maybe switch investments from stocks to bonds for the next year or so.

Christina Gayton

Written by

☆ Real Estate Agent at OPGNY. ☆ Majoring in Ethical Technoeconomics at NYU ☆ Poet, Model, and Actor at NYMMG. || ChristinaGayton.com || IG: @christigabriella

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