If people aren’t selling stocks because of the possibility of a government shutdown, they might be worried about the flattening yield curve—broadly defined as a time when short-term interest rates were higher than yields on longer-term bonds. Everybody knows that an inverted yield curve signals a recession, and aren’t recessions bad for the stock market?
The press has certainly made a big deal out of the so-called inversion of the yield curve. But an article by hedge fund manager John Mauldin points out, first, that the yield curve is not actually inverted. Look at the accompanying chart, which shows the curve for Treasury bonds two years ago (light gray line) vs. one year ago (darker gray) vs. very recently (blue). An inverted yield curve would have the left side of the blue line higher than the right—and that clearly is not the case—yet. The curve does seem to be flattening over time, but we haven’t seen an inversion. What the press has pointed out is that the three-year rate of 2.84% is slightly higher than the five-year rate of 2.83%—a very small inversion in a very small part of the overall curve. By the time you read this, the 5-year may again be yielding more than the 3-year.
Okay, but what if there IS a yield inversion? Mauldin looked at the historical record, and found that indeed recessions followed yield curve inversions, but it didn’t happen immediately. For instance, the yield curve was inverted in mid-2007, but the Great Recession slammed into the economy almost a year later. In fact, recessions could come months or even more than a year after the yield curve had turned upside down, and yields could return to normal patterns before any sign of a recession hit.
So, yes, professionals will be watching the pattern of bond yields closely going into next year, but you shouldn’t believe the hype of the headlines. Sooner or later, there will be a recession, and people following the bond market will probably get out of stocks prematurely, perhaps missing the last run-up in stocks. The markets just don’t send us clear signals about what they’re going to do, despite what you read, even though quick-twitch traders seem to be selling at the moment.
Stay Diversified, Stay Your Course!
