Yield curve inversions may be a key indicator of a recession on the horizon


Source/Disclosures


Disclosures: Bhatia, Mandell and Taylor report no relevant financial information.


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Now that the Federal Reserve has raised interest rates for the first time since 2018, many financial media are returning to the subject of inverted yield curves.

Because the term yield curve inversion has returned to the news, you may be wondering what it is, what it portends, and why it is getting so much press.


OT0622Bhatia_Graphic_01
Source: Sanjeev Bhatia, MD; David B. Mandell, JD, MBA; and Andrew Taylor, CFP

What is a yield curve inversion?

If someone is borrowing money from you, the time until they pay you back should be a determining factor in how much interest you charge. The longer it takes for you to be repaid, the higher the interest you will charge, because the greater risk you are assuming as a lender. For example, a 30 year mortgage has a higher interest rate than a 15 year mortgage. It’s common sense.

Sanjeev Bhatia

Sanjeev Bhatia

However, in bond markets, this return-time relationship is not always true. Rarely do bonds with longer maturities post lower interest rates than short-term interest rates. We then say that the yields are reversed.

What this means for investors

In simplified terms, when short-term rates are higher than long-term rates, the market says, “The good times are here…but the bad times are coming.” Central banks typically raise interest rates to curb inflation as the economy strengthens, but lower them to stimulate business activity when the economy is struggling.

David B. Mandell

David B. Mandell

Andrew Taylor

Andrew Taylor

Consider the following. As we write this in late May 2022, a 10-year treasury yields around 2.75% while a 5-year treasury yields 2.74%. The current relationship between 5-year and 10-year bonds is described as a flat yield curve, which could easily reverse within days. Typically, when discussing an inverted yield curve, most are referring to 10-year and 2-year Treasury bills. 2-year and 10-year government bonds reversed slightly at the end of April. At the time of this writing, the 2-year bond yielded 25 basis points (0.25%) less than the 10-year bond. The next round of interest rate hikes by the Federal Open Market Committee could again lead to an inverted curve.

Assuming investors have a long-term time horizon, what would induce them to buy the lower-yielding, more volatile long-term bond rather than just rolling a series of 2-year bonds at the same rate or roll over 5-year bonds at a higher rate?

Advantage of the 10-year note

Choosing the 10-year note makes sense if an investor thinks interest rates will fall enough over the next 10 years that locking in a long-term yield of 2.75% will produce a result at least as good as the yield with a series of short-term securities. obligations. Typically, some sort of recessionary event would be needed to push short-term rates down. Indeed, an inverted yield curve has preceded the last seven US recessions. This is why many investors are concerned.

However, it is important to remember that the yield curve reflects investors’ expectations for interest rates, inflation and economic growth. Investors are human, after all. There is no guarantee that the collective market prediction will come true. A recession did not follow the inversion of the yield curve in 1966. The market experienced a recession after a brief inversion at the end of 2019. However, the global pandemic was clearly the catalyst for the slowdown in the economy at the time. One can certainly question the predictability of the latest inverted yield curve, given how quickly the economy rebounded once pandemic restrictions were lifted.

Concern over an impending recession

Many commentators have offered plausible reasons why an inverted yield curve may not indicate an impending recession today. Among the reasons, the unemployment rate is 3.6%. Consumer spending accounts for 70% of the US economy, which is why we are currently missing a key component in a recessionary environment.

Moreover, current yields are more stable (equal across all bond maturities) than inverted. A flat yield curve is not a sign of a recession.

Additionally, a yield curve may remain inverted for some time before a recession occurs. Temporary reversals had limited predictive value.

Federal Reserve Chairman Jerome Powell recently challenged the predictive nature of inverted mid-term rates. He suggested that the Federal Reserve has research indicating that the first 18 months of the yield curve (comparing 30, 60, 90 day rates, etc.) are more effective predictors of recession. The 90-day Treasury yields 1.13% versus 2.75% for the 10-year, far from a reversal.

Conclusion

Recessions are difficult to predict. Typically, the economy is in a recession for several months before the consensus realizes it and economists confirm it. In fact, it can be argued that we are already in the middle of a recession. Financial growth in the United States (measured by gross domestic product) fell 1.4% in the first quarter of 2022. The Standard & Poor’s (S&P) 500 index fell nearly 20% from its peak in January and, if the second quarter data shows a second quarter of declining growth, it is safe to say that the criteria for a (very mild) recession are met. It is important to note that a modest recession is not an indicator that the stock market is heading for a sharp decline from today’s levels. The market is trying to forecast the economic environment a year from now. Slowing growth has been widely accepted and priced into equities, which is why the S&P has fallen by double digits year-to-date.

The unemployment rate is low at 3.6% and businesses are generally healthy despite some pressure on profit margins. A flat or slightly inverted yield curve alone will not change the current environment. The shape of the curve could be an indicator that conditions are about to change, but it should not be used as an infallible tool for making investment decisions.

Investing is certainly not without risk. One can always find a reason to worry about the economy and stock markets. Inflation and geopolitical unrest top the list today. The shape of the yield curve is worth observing. However, we believe that the shape of the yield curve (today) is no reason to change your long-term investment strategy.

References:

Wealth planning for the modern physician and Wealth management made easy are available for free in print or as an e-book download by texting HEALIO at 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.

www.statista.com/statistics/188185/percent-change-from-preceding-period-in-real-gdp-in-the-us/

For more information:

Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon practicing at Northwestern Medicine in Warrenville, Illinois. He can be contacted at [email protected] or @DrBhatiaOrtho.

David B. Mandell, JD, MBA, is a lawyer and founder of the wealth management firm OJM Group www.ojmgroup.com, where Andrew Taylor, CFP, is a partner and wealth advisor. You should seek professional tax and legal advice before implementing any strategy described here. They can be reached at [email protected] or 877-656-4362.

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