In this episode of “Investment Management Foundations,” Wealth Enhancement’s Vice President of Portfolio Consulting, Gary Quinzel, explains what the yield curve is and what it means when it’s inverted.
VIDEO TRANSCRIPT BELOW
Welcome to this edition of Investment Management Foundations. My name is Gary Quinzel, Vice President of Portfolio Consulting at Wealth Enhancement Group. Today's topic is, “What Does It Mean When The Yield Curve Is Inverted?” You may have heard a lot about this; it's been in the news for quite some time. The question you may be asking is, “What exactly does it mean when the yield curve is inverted?” That simply means that the cost of borrowing money is more expensive than what you get for saving long term. Okay, that's fine. But what does it mean from an investing standpoint? There's been a lot of talk in the financial press about an inverted yield curve signaling that a recession is forthcoming. The reason why that has been the case is because going all the way back through history, we've seen many, many times where, in fact, that did happen. In fact, there's also an adage that says an inverted yield curve has correctly predicted 12 out of the last 10 recessions. I joke about that because not every single inverted yield curve necessarily has signaled a recession. But there is a fairly good track record, as this chart demonstrates.
What's really interesting about an inverted yield curve has implications I want to dig into just a little bit and talk about what it means from an investor's standpoint. I already mentioned how the cost of short-term borrowing is more than what it is than what you're being rewarded for sitting for long term. But another way of evaluating an inverted yield curve is that the market is pricing in lower growth further out, while the short end of the curve is priced higher based on the Fed’s efforts to stem inflation. As we know, we've had a little bit of an inflation problem these last couple of years, and the Fed has had to significantly increase the short-term Fed funds rate to help slow down the economy and bring down inflation. This has a number of different signals. And either way you look at it, an inverted yield curve is said to be recessionary. Because it's just contradicting the notion that investors are supposed to be compensated for holding longer term bonds.
Now, there's just a theory that's baked into how we value a debt instrument, we discount the future value of cash flows back over time; this is how we price bonds. And there's this concept that investors that are holding that are going to invest in bonds over the long term are supposed to be rewarded for having their money locked up—we call that the term premium. Or in other words, that additional payment that an investor is supposed to be receiving over time, in exchange for investing in longer dated debt. So again, this concept that, you know, for an inverted yield curve to normalize, this is going to require the Fed to change what they're doing, they're actually going to have to lower interest rates, which will be a reaction to a slowing economy. Or on the other hand, the other thing that can un-invert a yield curve is investors would have to sell longer-term bonds in expectation of higher inflation. Regardless of either of those two things happening, those can tend to signal a recession, because if the Fed is slowing to it, it’s actually going to lower interest rates, that's actually their way of saying that they're expecting rates to come down. And as we're seeing right now, the Fed is actually in a current hole with their interest rate policy, because inflation is actually staying high. And they actually don't see the economy slowing down right now.
The other thing you'll notice from this curve from this graph is that there's always a lag between an inverted yield curve and when recessions actually occurred, and those that lag can range from just a few days to several months. So, it can be extremely challenging to say the least to use an inverted yield curve as a way for market timings. In fact, I would adamantly advise against it, you really can't predict when the market is going to turn based on the yield curve. However, there are some important takeaways for you to consider as an investor. An inverted yield curve simply tells you that the short-term rates are higher than they are long term. Eventually, the Fed will lower rates on the short end, and rates on the longer end should go higher—that’s normalization. But as investors, we can take advantage of the positioning of the yield curve. And there's always an opportunity to invest along steeper parts of the yield curve. So, any yield curve can create opportunities. As investors, we look for those opportunities as we optimally position our clients’ money for future long-term success. We hope you found this episode interesting about the inverted yield curve. We hope you tune in for our next episode. Thank you so much.
This information is not intended as a recommendation. The opinions are subject to change at any time and no forecasts can be guaranteed. Investment decisions should always be made based on an investor's specific circumstances. Investing involves risk, including possible loss of principal.
