The market took a big dive yesterday and the news media screamed about an inverted yield curve and a recession. You might ask, so what is an inverted yield curve?  During most times, investors require higher payments (yields) for buying longer-dated bonds. Or think of a CD –  a bank typically pays you more interest for a CD that matures in 5 years compared to one that matures in 3 months.  But sometimes (like now) things change and a shorter-term bond pays a higher interest rate than an longer-dated bond.

Should you be worried by the inversion?  The answer is let me be worried for you because it’s not an easy yes/no question.

  • Historically, when a yield curve inversion has preceded a recession, there has been a lag of 1-2 years between the inversion and the beginning of the recession. So it’s not like we’re heading into recession imminently. In fact, economic data released this morning (retail sales, productivity, sentiment indicators) all posted better than expected results – results that are not at all consistent with an economy heading into recession.
  • This particular inversion has much more to do with what’s happening in the rest of the world than in previous instances. US interest rates are much higher than in Europe or in Japan, so money tends to flow into US bonds, driving prices up and yields down.  Why would a German insurance company put money into a German bond that pays nothing when that money could be put into a 10-year US Treasury paying 1.75%?  So what’s happening in the rest of the world is putting downward pressure on long-term US bond yields while the Federal Reserve is keeping short-term rates higher. The result is the current inversion.
  • According to economists with the Federal Reserve, “an inverted yield curve doesn’t forecast recession; it forecasts conditions that make recession more likely.” The extent to which a recession does, or does not, follow the inversion has a lot to do with the specifics of the economy at the time. Time and additional data are required before we can say that the economy is headed into recession.

I suggest you continue to take the news media and scary headlines for what they are – less than forthright depictions of reality designed to get you to watch more TV or click more website links – all for the purpose of selling more ads. At the same time, we’ll be watching for indicators that economic conditions are changing for the worse. That certainly has not happened yet, but we’ll be watching.

If you would like to read more about the yield curve inversion, there are two articles – one written by two economists with the Federal Reserve and a second from the Wall Street Journal. You can find them here and here.

If you have questions or would like to talk, please let me know.