The Inverted Yield Curve: Should You Care?

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We’ve seen the phrase “inverted yield curve” making frequent appearances in the financial news in the last couple of weeks, typically because this phenomenon, currently a feature of our bond market, is being linked with predictions of a recession. This, in turn, has created lots of downward volatility in the stock markets, as a recessionary economy is a difficult environment for most businesses to negotiate profitably.

Many may not clearly understand what an inverted yield curve is or what its implications are for fixed-income and equity investments. So, let’s start with a few basics.

What Is the Yield Curve?

The yield curve signifies the yields available for fixed-income investments (typically bonds) at various maturities, from very short-term (money-market funds and three-month U.S. Treasury bills, for example) to very long-term (like 30-year Treasury bonds). A normal yield curve shows lower yields for short-term investments and higher yields for longer-term bonds. This makes sense, because when money is locked into a longer-term bond, the risk is higher that rates (and yields) will move in an adverse direction at some point during the term. With short-term investments, on the other hand, the risk is typically much lower, so the yield can also be much lower.

What Does It Mean When the Yield Curve Is Inverted?

When the yield curve is inverted, it means that the yield on longer-term bonds has fallen below the yield on shorter-term obligations. Currently, for example, for a brief period of time last week, the yield on the 10-year U.S. Treasury bond fell below that of the 2-year bond, and this was not the first time this has happened in the last several weeks. In other words, the bond market was indicating that investors perceive a higher risk in short-term bonds than in long-term bonds, thus creating an inversion of the usual yield curve.

This is significant for the stock market, because every recession since the 1950s has been preceded by an inverted yield curve. However, it is far from certain exactly how much the inverted yield curve precedes the recession; historically, the lag has been anywhere from a few months to two years. In fact, some inverted yield curves have proven to be “false positives”; not all of them were followed by a recession.

For fixed-income investors, such as many of my thriving retirees and women in transition, the implications are somewhat different. Because these investors want to obtain the highest yields possible in order to generate a steady stream of income, the prospect of greatly lower yields in the future is not so appealing.

What Does an Inverted Yield Curve Mean for Investors?

With a few basics in place, let’s discuss how investors — both stock and bond investors — should react to the current unusual interest rate environment and its effects on the financial markets. First of all, despite the increased volatility in the stock market, I strongly advise against knee-jerk, panicked selling based on fear of a recession. First, as mentioned above (and also in recent remarks by former Fed Chair Janet Yellen and other economists), there is no guarantee that the inverted yield curve is signaling a recession. Second, even if a recession begins, it could be two years or more in the future, which means that exiting the stock market now could mean leaving lots of upside on the table. Rather than reacting emotionally, it is always better to stick to your long-range strategy, review your allocations, and use market pullbacks — which are part of every normal market cycle — as opportunities to rebalance.

For fixed-income investors, especially those with bonds maturing in the near future, it may be time to look toward the five-year range in order to lock in slightly longer-term rates that may be unavailable in the future. And always remember that, though bonds can and do fluctuate in value, just like any other investment, if you hold high-quality bonds (U.S. Treasuries and highly rated municipal and corporate bonds), you have a locked-in income stream — the “drip” that is so important to my clients — from the interest payments, along with the return of the face value when the bond matures.

The most important thing, to sound once again a theme that I constantly return to, is to stick to your strategy and make sure you’re listening to solid, professional advice. Don’t base your financial decisions on the headlines, which are intended only to generate clicks, “likes,” “shares,” and advertising revenue. If you have bonds maturing and you’re wondering what you should do, please come talk to me. If you’re concerned about your stock portfolio, let’s have a conversation and review your risk profile and your asset allocations. But remember that broad diversification, rebalancing, patience, and discipline are your most reliable tools for this or any other time in the financial markets.

Stay Diversified, Stay YOUR Course!