Have No Fear! Why the Recent Inverted Yield Curve Should Not Cause Panic



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Yesterday, investors woke up to the news that the yield curve has inverted, which means that short-term bond yields are higher than long-term bond yields.  In this case, investors were focused on the difference between the 2-year and 10-year U.S. Treasury bond yields.  This is considered to be worrisome because a yield curve inversion has preceded all seven recessions since 1960.  The stock market reacted with a steep selloff, resulting in the major indices falling ~3%.  Investors are now left to wonder, is a recession imminent?  For a number of reasons, we don’t think so. 

First, we believe that yesterday’s market reaction was less about thoughtful long-term investors adjusting their portfolios, and more about computer algorithms triggering sell orders once the yield curve inversion occurred.  Consider that the yield curve was +0.01% as of Tuesday’s close (when the stock market rallied), dipped to -0.02% the next morning, and closed yesterday at +0.01%.  This is not what we would describe as a seismic or alarming shift. 

Second, although an inverted yield curve has preceded every recent recession, recessions normally occur on average 18 months after the inversion, and the stock market typically rallies an average of 13% during the year following the inversion.  So, while an inverted yield curve may portend trouble on the horizon, a recession typically takes quite a while to materialize.  Further, an inverted yield curve does not necessarily mean that a recession is imminent.  There have been two instances since 1960 (1967 and 1998) where the yield curve inverted and there wasn’t a subsequent recession at all.

The third (and possibly most important) point is that we are in a very unusual environment for global bond yields, and this probably isn’t a garden variety yield curve inversion.  Ordinarily a drop in long-term yields leading to a yield curve inversion is a result of investors rotating out of risky assets (such as stocks) and into safe assets (such as long-term bonds) in anticipation of an economic downturn.  In this case, it is more likely a result of foreign investors seeking better yields in U.S. treasury bonds.

To explain, the extraordinarily loose monetary policies implemented by global central banks over the past decade have had an astonishing effect on global interest rates.  In addition to the extremely low level of interest rates in general, there is currently more than $15 trillion in government bonds around the world that actually have negative yields.  For example, if you were to invest $10,000 in a 10-year German government bond (Bund) at the current yield of -0.65%, you would only receive $9,369 when the bond matures.  This completely defies logic, and the current magnitude of this phenomena is unprecedented.  As foreign investors search for ways to safely invest their money, there is growing demand to purchase long-term U.S. Treasury bonds with positive yields as an alternative to comparable government bonds with negative yields.  This demand by foreign investors has driven long-term U.S. Treasury bond yields lower, which contributed to the yield curve inversion. 

Finally, our clients’ portfolios are constructed for long-term time horizons and are meant to (hopefully) weather recessions, correction, and bear markets.  This allows our clients to remain on track to reach their financial goals despite the inevitable twists and turns in the market.  We don’t claim to know when the next recession or bear market will occur, but we feel confident that our clients are appropriately positioned, even as these short-term declines occur.

Thank you very much for your continued confidence in our service and advice. If you would like to discuss our opinions, outlook, or your portfolio in greater detail, we would be happy to schedule a meeting or a conference call at your convenience. Lastly, don’t keep us a secret. If you know someone who would like help planning for their financial future, we will be pleased to speak with them to see if we can assist.

Horizon Wealth Advisors is a Houston based fee-only wealth management firm. Horizon is a fiduciary advisor. We specialize in helping successful individuals and families understand, organize, and manage their often complex financial situations. Horizon offers integrated financial planning and investment management services.

Owen Murray, CFA
Owen Murray joined Horizon Advisors in 2005. As a core member of the wealth management team, Owen is principally involved in investment research and portfolio construction.

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