September 2019: Investing Insights
There are a few certainties in this world. Death, taxes, and the Detroit Lions missing the playoffs are a few of these. Another one of these certainties is the business cycle. There are different names given to the stages, but the shape is the same:
Rinse and repeat for the past two hundred years. Yet, for the past 10 years, since the end of the Great Recession, there has been no cycle at all. Rather just a straight shot higher, as the economy has been stuck in expansion mode. However, as we all know, eventually the good times end. And according to this Recession Indicator, the good times may be ending sooner rather than later.
In the past week, the U.S. yield curve has inverted. This inversion has correctly predicted the last 9 recessions over the past 50 years. This article addresses the Inverted Yield Curve and what it may mean for the economy and your portfolio.
What is the yield curve?
The yield curve shows how much government bonds are yielding at different maturities. Starting with lower maturity bonds on the left-hand side of the chart and moving to longer-maturity bonds to the right. As you would expect, the normal yield curve is upward sloping. Meaning that if you buy a bond for 2 years you will receive less interest than if you buy a bond for 10 years. You would expect to earn a higher yield if you are willing to buy a bond that has a longer-term.
However, things are not normal now. Today you will get a lower interest rate if you buy a 10-year government bond, compared to a 2-year government bond. This is called an inverted yield curve. Here is what the current yield curve looks like:
Source: U.S. Treasury as of 8.28.19
As you can see from the current yield curve, you can lend the government money for three-months and earn a higher interest rate than if you earn the government for thirty years. This isn’t normal.
Why is the yield curve important?
Typically, I would argue that the yield curve doesn’t matter. Well, at least you don’t hear it being talked about daily on CNBC like it is today. However, an inverted yield curve is important. An inverted yield curve has predicted the past 9 recessions over the last 70 years. Only one time has the yield-curve inverted and there has not been a recession shortly after. Most investors look at the “2-10” yield curve inversion. Meaning that you have a higher yield with 2-year bonds, currently 1.50%, vs. 10-year bonds, currently 1.47%.
What causes the yield curve to invert?
There are typically two things that cause the yield curve to invert: The Federal Reserve raising short-term rates too quickly, while investors continue to buy longer-term bonds.
You have probably heard that until recently the Federal Reserve has been raising interest rates. However, the Federal Reserve only controls shorter-term interest rates. The Federal Reserve raised the federal funds rate from 0.00% to 2.25% from December 2015 to December 2018. This caused short-term interest rates, and checking/savings account interest, to move higher. However, last month the Federal Reserve went backward and lowered interest rates back to 2.00%. According to the President, they need to lower even further.
The issue though isn’t just that short-term rates have gone up. The bigger problem may be that longer-term bond yields have gone down. As I mentioned previously, longer-term bonds are not controlled by the Federal Reserve, they are controlled by supply and demand. Currently, there is a lot of demand for U.S. longer-term bonds. The reason why? The U.S. may have low rates, but it is nothing compared to the rest of the world. In the U.S., you will earn nearly 1.5% annually for investing in a 10-year bond. Want to buy a 10-year bond in Germany? Currently, the interest rate is -0.70% on a 10-year German bond. That’s right, you will lose 0.7% annually by investing in a German bond. This is the reason that there is a high demand for U.S. bonds, which has caused rates to plummet as bond prices have skyrocketed.
So, should you panic?
Not necessarily, or at least not yet. In fact, after a yield-curve inversion, the stock market has historically done very well. Typically, a yield-curve inversion does not mean an immediate recession and stock market sell-off. It usually takes about 18 months before the stock market really struggles after a yield-curve inversion. Also, the stock market typically does well over those 18 months after a yield curve inversion, earning nearly 16% on average during that time period. A recession typically occurs 22 months after a yield-curve inversion. According to history, it doesn’t make sense to panic. Yet.
Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.– Peter Lynch
It really should come as no surprise that we will face an economic downturn in the somewhat near future. If that is later this year or a couple of years in the future, recessions and market drops are a normal part of the economic cycle. It now has been 10 years since the last recession, which is about twice as long as the average. However, people have been forecasting the next recession for the past 6 years. Trying to time a market drop and recession is typically a losing game. Make sure that you have a portfolio that is positioned for the long run. This means that you can take advantage of the good times, without panicking and selling when things get tough. As we all know, things will get tough again.
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Bryan Haggard CFP®, CFA is a fee-only financial planner. He specializes in working with families to help them live a stress-free retirement. Interested in putting together a plan to help you meet your retirement goals? Schedule a time to meet below.