Yield Curve Inversion and Confusion (And Savers Get Paid Again!)
“In the midst of every crisis, lies great opportunity.” – Albert Einstein
Market and economic forecasters are constantly looking for signals in the market to predict a recession. One of the most common is when the bond market inverts, i.e., when short-term interest rates (such as the yield on a 2-year Treasury bond) are higher than long-term rates (such as the 10-year Treasury). Recently, this happened for the first time since 2019 as the Federal Reserve has started to raise short-term interest rates and work to normalize monetary policy (good news finally for savers). This brief inversion increased the fear of a coming recession. We outline why we believe the fear of this signal is overblown, and as an investor, you are best served by sticking to a well-structured investment plan. But first, a primer.
What is a yield curve?
A yield curve is a line that plots interest rates of bonds with equal credit quality yet different maturity dates, such as the recent Treasury yield curve below, along with similar plots at year-end 2020 and 2021.
There are three main yield curve shapes: normal (upward sloping curve), inverted (downward sloping curve), and flat. Most of the time the yield curve is upward sloping as investors demand a higher yield (or more income) for lending money out for longer periods.
Fixed-income securities are especially sensitive to interest rate increases due to the inverse relationship between bond yields and prices. Despite increased short-term volatility, it’s important to remember the role fixed-income plays in your portfolio – diversification, preservation of capital, and income generation.
Why does it matter?
The yield curve slope indicates future interest rate changes and economic activity. Many see the yield curve as a signal of economic health as short-term interest rates are influenced more by policy set by the Federal Reserve. However, long-term interest rates are more determined by investors and traders who reflect the market sentiment of economic growth and inflation.
So why do we pay attention to the yield curve, and why has it been in recent headlines? Yield curve inversions have historically been a reliable predictor of coming recessions. There have been six official recessions since the mid-1970s, and the average span between inversion and recession was 12 months, ranging from 6 to 22 months. However, yield curve inversions are often viewed as a cause of recessions, when in fact, they are better thought as a symptom of the conditions that tend to lead into a recession.
Source: Charles Schwab, Bloomberg, as of 3/18/2022.
While we know for certain that a recession will happen at some point in the future as the laws of economics and the business cycle have not been repealed. Today’s rising interest rates, high inflation, surging oil prices, and geopolitical tensions have all added to economic uncertainty. As a general rule, markets react negatively to increased uncertainty. However, it is important to note that the underlying fundamentals of the market are still strong: current unemployment numbers continue to decline, consumers are spending more than they did a year ago, commercial lending standards are still favorable, and overall economic activity is up…to name a few. So a recession does not appear immediately imminent in our view.
This recent inversion in the yield curve can make it tempting to abandon a well thought out investment plan, but history shows that can be a mistake. From the time a yield curve inverts, it can take upwards of 2 years for markets to feel the negative effects of a recession (lower economic activity and ultimately stock prices). Blackrock recently published data going all the way back to 1926, where they looked at the 10 worst starts to a year in fixed income markets. In the following 8- and 12-month periods after these declines, fixed income markets showed a positive 5.2% and 7.3% return, respectively. More importantly, 90% of the time, the next rolling 12-month period showed positive bond returns. Stocks on average have delivered positive returns a year following an inversion of the yield curve. Higher interest rates can be a negative for the stock market, as the cost of doing business rises for companies and the possibility of slowing growth rises. However, Bloomberg data shows that in each of the last eight hiking cycles, the S&P 500 was higher a year after the first interest rates increase. In fact, if we look at the 25 worst 1-year periods for the fixed income markets since 1926, the S&P 500 has increased an average of 13% just one year later. While past performance is never a guarantee of future results, history and data advise staying the course.
The Answer: Stick to a Well-Constructed Investment Plan
Madison is dedicated to helping navigate these choppy waters and keeping our clients on track to meet their personal or family goals. We’re continuing to monitor markets and investments, prepared to make adjustments as necessary. We’re always a phone call or email away.