How Will The Inverted Yield Curve Affect Me?
An inverted yield curve is when the yields on bonds with a shorter duration, such as that of two-year treasury notes, are higher than the yields on bonds that have a longer duration, such as that of 10-year treasury notes. This type of treasury yield curve can help to predict a recession, which makes it relevant in decision making for investors.
Understanding what an inverted yield curve means
When the economy is doing well, the rate on longer-term bonds are likely to be higher than its shorter counterparts as the extra interest is meant to compensate the risk that the strong economic growth may wear off in the long run due to inflation and other factors. The converse is true when the economy is performing badly. In this case, for the banking sector, the flattening of the yield curve can translate to lesser profits since the business is centered on borrowing money at short-term rates to lend it to consumers at long-term rates.
For investors, an inverted yield curve may signal low confidence in the near-term economy. This is especially so as recessions typically run for 18 months. An investor who believes that a recession is impending will prefer treasuries that are above two years. In essence, a higher short-term interest rate or a lower long-term interest rate are both believed to be a strong signal of an economic recession. In addition, the act of believing that a recession is impending because of the inverted yield curve can end up becoming a self-fulfilling prophecy since investor confidence will be directly affected.
Past and current predictions
Previously, the curve predicted the 2008 financial crisis two years in advance. The curve has also inverted prior to the recessions of 2000, 1991, and 1981. Its historical accuracy has caught the eye of many investors and professionals.
Recently, strategists at Morgan Stanley predicts that there will be a recession in 2019 based on the inverted yield curve, and is recommending investors to overweight treasuries and underweight corporate bonds. The prediction of a possible slump has also been reported by CNBC.
Against the inverted yield curve
That said, some argue that the yield curve should be taken with a pinch of salt as central banks can influence the short and long term rates significantly as compared to the free market. Central banks can purchase government bonds to push long-term rates lower. This can artifically depress the bond yields. When short-term rates are expected to be lower, it also shows that the market can expect monetary policies to ease accordingly.
The continual evolution of the economy can also tweak the reliability of the yield curve as a sign of economic health. What was accurate 10 years back may not be applicable in the changing economy today. Looking at historical data that worked in the past does not mean that it will continue to work. In a similar vein, the Fed has been looking for alternative signals to guide their policy. New research found that the difference in current interest rates on 3-month Treasury bills versus 18 months served may be a stronger symptom of a recession in the coming year.
So… What should I do?
Thankfully, inverted yield curves are not everlasting, as such, do not beat yourself up over it.
If you are heavily invested in long-term items, you may see interest rates for such bonds dwindling lower. If you are repaying a loan for a home or any other large ticket items with an adjustable interest rate schedule, you may be affected depending on the period of repayament as well. Being prepared for rainy days is important, whether or not the inverted yield curve is accurate or otherwise. Knowing that you can pull through a recession by living within your means and cutting down on unnecessary purchases can put your mind at ease. This stable state of mind is important when making investment decisions as a wrong move can result in both short and long term losses. You should be confident in getting by with your current savings even in the event of short-term unemployment as well. As such, take the invert yield curve as a reminder to have sufficient savings and a diversified investment portfolio.
It is important to not jump into conclusions too quickly based on speculations or inflated predictions. Sieving out all the chatter is helpful in maintaining your long-term portfolio. Remember that you are not able to control the market, and that you can only move along and decide your next course of actions accordingly. Take in a deep breath and relook at your portfolio. Build your own school of thought to guide you through storms. It may literally pay to be more cautious during this period.