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Significance of Inverted Yield Curves

Investors can hardly pick up a recent financial publication without seeing a headline or two about inverted yield curves. This is understandable, as financial reporters earn their salaries by writing about unusual or newsworthy events. An inverted yield curve certainly qualifies as unusual, given that before March 2019, the yields on 10-year U.S. Government Treasury bonds have not dropped below the yields on 2-year bonds since the recession of 2008 and 2009.

Equity markets have already reacted to this inverse yield, and they continue to react with wild swings and selloffs followed by bargain-hunting buying sprees that drive equity prices back up. This poses a perplexing question for the average investor: whether to prepare for a recession or to hold the course and reject the mob mentality that characterizes the investment marketplace.

The more general question is whether a recession is truly on the horizon. Inverted U.S. Treasury bond yield curves have preceded each of the last seven recessions. If the relative returns on long versus short term bonds remain inverted for any length of time, in all likelihood the domestic economy is facing a looming recession. Investors might tell themselves that other market factors and conditions are different now, but yield curve inversions appear to be one of the few indicators with a higher degree of reliability.

The onset of a recession is often not acknowledged or understood until well after it happens. When analyzing past recessions, most economists perceive a 9- to 24-month gap between the occurrence of an extended inverted yield curve and the start of a recession. To the extent that the yield curve went upside down in 2019, the real effects of a recession might therefore not be felt until well into 2021.

This is far from an absolute certainty, but intelligent investors will continue to monitor the yield curves and other signs of an economic downturn as they map out their investment strategies. Some analysts see bond yield inversions as evidence of market glitches or of instantaneous reactions to global trade tensions and other events. Seth Carpenter, a former U.S. Treasury and Federal Reserve official and the current chief US economist at USB, remarked that an investor “would be an idiot to ignore the yield curve but it is nor proof that a recession is coming by itself.”

In an attempt to explain the recent inversion in yield curve ratios, analysts are looking at other factors that may distinguish the current market from previous instances of recessions that were preceded by inverted yield curves. The effects of the Federal Reserve’s bond purchases following the 2008 financial crisis, for example, are still reflected in 10-year bond yields that are lower than expected. Investors are also rushing out of low- or negative-yield European and Japanese debt instruments and putting their funds into more attractive short-term U.S. bonds.

Ed Clissold notes that his firm, Ned Davis Research, looks at other indicators to predict a recession, including indices of manufacturing and non-manufacturing activity, the Consumer Confidence and CEO Conference Indices, and other common economic gauges. Clissold has opined that “measures of economic activity imply that economic growth is slow, but positive”.

This flood of information requires extensive filtering of the signals of an impending recession from the noise of normal market movements and emotional investor reactions. Timing the markets is never an easy task; timing the start of the next recession is virtually impossible. The best that an investor can do is to compare previous inverted yield curves within the context of events surrounding them. The Federal Reserve’s quantitative easing program in 2008 is a perfect example. The central bank’s actions drove yields to historic lows that continued into 2019. Escalating rhetoric and the imposition of tariffs on trade with China add unprecedented external influences and distortions on the yield curve ratios.

What role will human psychology play as either a cause or amplifier of a recession? The March 2019 yield curve inversion did not last, but investors jumped to pull funds out of the markets quickly when the inversion was first detected. The emotional instantaneous response is distinct from long-term investor reaction when the yield curve ratio remains inverted for several weeks. Investors can find multiple opportunities between the onset of an extended inversion and the true beginning of a recession, which, as noted, can occur between 9 and 24 months later. The investors who stayed in the market when the yield curve inverted in February 2006 realized gains of 12% to 25% or more before the markets began to crash in earnest in October 2007.

The net of all of these elements is that the economy is at risk of falling into recession, but that risk is not absolute, and any number of factors could push the economy either closer or farther away from recession. Goldman Sachs chief executive, David Solomon, observed that the underlying economy is doing okay and that the near term risk of recession is low. Along with Jan Hatzius, Goldman’s chief economist, he sees that risk being exacerbated by trade wars and tariffs. JPMorganChase’s chief economist, Bruce Kasman, sees a recession risk in the range of 40% to 45% over the next 12 months. Overall, roughly three-fourths of economists responding to a National Association for Business Economics survey believe that the economy will be in a recession before the end of 2021.

The best that a smart investor can do is to continue to watch the yield curve, monitor other relevant indicators within the context of national and world events, and avoid emotional reactions that cause wild market swings. In this environment, a disciplined and strategic plan is an investor’s best friend.