Is the Inverted Yield Curve a Sure Sign of Recession?

According to many experienced and credible analysts, an inverted yield curve is a surefire sign a recession is coming. At present, the U.S. economy is facing an inverted yield curve and, as a result, many investors and economists say a recession is inevitable. However, most investors do not fully understand what this means, and that lack of knowledge paired with the current media mentality that “the sky is falling” represent the greatest danger to any portfolio.

Here are some basics you need to know about the inverted yield curve:

  1. Inverted yield means short-term interest rates are higher than long-term interest rates.

What interest rates are we talking about? The yield curve usually uses the yields of U.S. Treasury bills, notes, and bonds. The curve usually slopes upward, since short-term loans tend to have lower interest rates than longer ones and, similarly, money you give to the government to use for a short time is rewarded with less interest than money you offer for use for a long time. When that line becomes inverted, it means the short-term use is being rewarded at a higher rate than long-term use, which is an anomaly. In an inverted situation, a two-year bond might offer a yield of 5 percent, for example, while five-year bonds offer 4.5 percent and 10-year bonds offer 3.5 percent.

  1. Duke University Professor Campbell Harvey linked yield curve inversion to recession in 1986 and has had “no false signals yet.”

Harvey linked situations in which short-term interest rates exceed long-term rates to recessions more than 30 years ago by studying the four recessions from the 1960s to the 1980s. The three recessions that followed the publication of his dissertation on the subject also held to the same pattern. It is worth noting, however, that while Harvey states his model has shown “no false signals yet,” some economists read the 2007 yield curve that preceded a global recession as flat rather than inverted.

  1. Three-month and 10-year Treasuries are the ones to watch.

Economists have been using the yield curve for decades, and an inversion has historically been a good indicator that an economic slump might be coming. Three-month and 10-year treasuries, on opposite extremes of the spectrum, are the two measures that seem to most reliably, when inverted, predict economic slow-down. However, particularly in today’s highly managed markets, the yield curve could also predict aggressive fiscal policy moves from entities like the Federal Reserve and global central banks and policymakers. The timing of a recession will hinge, in all likelihood, on what types of interference the markets experience as a result of the brouhaha.

  1. Do not stop investing activity but consider your own timelines.

Because self-directed investors tend to have investments in alternative assets like real estate and other assets that permit flexibility and creativity, the important thing for investors to do right now is evaluate their strategies in light of a potential economic shift. If your strategies rely on other consumers retaining high levels of confidence (for example, if you are starting a new business or creating returns by flipping houses), then you may want to keep a close eye on how the yield curve is affecting investor and consumer confidence levels. On the other hand, if your strategy relies on providing a service or product that is needed as much or more during a downturn – say, affordable housing, for example – then you might actually opt to ramp up your activity in preparation for what might be a looming recession.

How Long Do We Have?

Harvey believes the Fed can only control the yield curve for so long, and most economists agree with him. Furthermore, most analysts agree that the current economic uptrend cannot continue indefinitely, although opinions are definitely mixed when it comes to deciding whether there must be a recession or whether an economic plateau might be another scenario. For most self-directed investors, the key to using a yield curve for investing purposes is to make sure that your investments will not suffer in the event that there is an economic slowdown or, also important for many investment strategies and asset vehicles, in the event of a downswing in consumer confidence.

Tell us what you think:

  • Is a recession coming?
  • Are you worried about the yield curve?
  • Have you adjusted your investment strategies yet?

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