The Yield Curve Conundrum
When the yield curve inverted briefly on the morning of Aug. 14, 2019, it set off chatter that a recession might be lurking on the distant horizon. Economic experts began popping up on newscasts everywhere. Headlines screamed statistics about the relationship between an inverted yield curve and recessions. Although it lasted only 2 hours and 15 minutes, the inversion was long enough to cause a sell-off in equity markets.
Investors have good reason to be nervous when the yield curve inverts. Historically, inversions have been a mostly reliable indicator of a recession; in fact, seven of the last nine recessions started with a prolonged inverted yield curve. And while it’s been over a decade since the recession of 2008, investors still remember the pain they experienced during that financial crisis.
While an inverted yield curve is a mostly accurate indicator of a looming recession, it’s also a slow one. In those seven instances when an inversion preceded a recession, it did so by an average of 22 months. As an example, let’s look at what occurred in the mid-2000s, leading up to the financial crisis of 2008.
On December 22, 2005, the U.S. experienced its first inversion since the 2000 recession. The Federal Reserve had been raising fed funds rates since the summer of 2004, and they were at 4.25% when the yield curve inverted the first time three days before Christmas. The Fed raised rates – again – one month later, and the yield curve inverted – again – shortly after.
The Fed kept nudging rates upwards until ultimately landing at 5.25% in July 2006. Investors disagreed with the Fed’s actions, and their disagreement was clear as the yield on the 10-year U.S. Treasury note (5.07%) fell below that of the two-year note (5.12%). The yield curve inverted – and stayed that way for nearly a year.
Between June and September 2007, the yield curve shifted indecisively between inverted and flat. The Fed decided to take action in September and lowered the fed funds rate to 4.75%. Over the following year they would lower rates 10 times, eventually hitting zero in late 2008. By then, it was too late; the financial crisis of 2008 was already underway.
How do current factors compare to those in 2006? For one, we are in a much different interest rate environment. In contrast to raising rates – and keeping them there – in 2006, the Fed cut them in late July by 25 basis points, dropping from 2.50% to 2.25%. And they’re probably not finished; the Fed is expected to lower rates again in mid-September.
As in 2005-2006, we have experienced multiple yield curve inversions over the last ten months: December 3, March 22, and August 14. However, one key difference stands out. Let’s revisit one of the statistics mentioned earlier: Seven out of nine of the last recessions started with a prolonged inverted yield curve. The inversion that signaled the 2008 crisis spanned 12+ months; the inversion on August 14 lasted 2.25 hours.
Knowing all this, should we batten down the hatches and brace ourselves for a recession in 2020 or 2021?
Signals are mixed. Some numbers – such as employment – remain strong, although appear to be softening somewhat. A trade deal with China remains frustratingly out of reach and will continue to weigh on investors’ minds. Uncertainties will abound as we head into what will undoubtedly be a contentious election year.
The good news? Opportunity for growth exists. Stocks have historically performed well in the 18 months following a yield curve inversion. And as always, it’s critical to ensure client portfolios are appropriately allocated before the storm hits. Now is a great time to meet with clients, reassess their risk tolerance, and realign their allocations to match.
i. Thomas Franck. CNBC. Aug. 13, 2019. “Main yield curve inverts as 2-year yield tops 10-year rate, triggering recession warning.”
https://www.cnbc.com/2019/08/13/us-bonds-yield-curve-at-flattest-level-since-2007-amid-risk-off-sentiment.html. Accessed Sept. 6, 2019.
iii.Kimberly Amadeo. The Balance. Aug. 27, 2019. “Inverted Yield Curve and Why It Predicts a Recession.” https://www.thebalance.com/inverted-yield-curve-3305856. Accessed Sept. 6, 2019.
iv. Thomas Franck. CNBC. Aug. 14, 2019. “After a key yield curve inversion, stocks typically have another year and a half before doom strikes.”
https://www.cnbc.com/2019/08/13/after-yield-curve-inverts-stocks-typically-have-18-months-before-doom.html. Accessed Sept. 6, 2019.
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