There’s a lot of anxious buzz in the news lately about thepotential for a market downturn – or even another “great recession” as someoutlets are calling it – which was sparked largely by the brief inversion ofthe yield curve on Wednesday, August 14th. Specifically, the yieldon 10-year U.S. Treasury notes fell lower than yields on the 2-year Treasurynote, which left investors unsettled over the possibility of arecession hitting the U.S. economy in the near future.
As an investor yourself, should you be worried about theyield curve or should it be chalked up to overblown media hype? The answer ismore considerably complicated than a simple “yes” or “no” in regards to whetherthe yield curve is important; there are many other factors to consider andtiming the markets rarely works well for any investor (even the mostexperienced ones), so now is not the right time to withdraw all your investments in a panic andhunker down for another 2008-esque doomsday scenario.
Before you rush to withdraw from the stock market and pour money into gold investments, there are some things you need to know about the yield curve to help you make informed investment decisions and maintain long-term gains for your portfolio, regardless of whether another recession hits the U.S. economy within the next 1-2 years.
What is the YieldCurve?
The “yield curve” is oftentimes referred to as the“benchmark curve” that visually depicts yields among U.S. government-backed maturitiessuch as Treasury notes and bonds. Most of the time, the yield curve ispositive, which signifies returns on investment for those who buy notes andbonds. The yield curve is typically viewed as a reliable indicator of a potential recession on the horizon, butthis shouldn’t be mistakenly viewed as a guaranteedpredictor.
Concerns over short- and long-term economic growth arisewhen a yield curve begins to flatten; bond investors generally pay closeattention to this economic indicator because it can majorly impact theirreturns on investment over time. Short-term bonds and Treasury notes (3 monthsto 2-5 years) tend to have lower yields in comparison to long-term notes andbonds (10+ years) because they’re less risky for investors.
On a graph, a normal yield curve slopes upward from left(short-term maturities) to right (long-term maturities). This reflectsinvestors’ expectations that the economy will generally grow at a similar paceover a long enough timeframe.
An inverted yield curve looks the opposite of a normal yieldcurve: it slopes downward from leftto right, which means there are lower yields on long-term maturities incomparison to short-term maturities. But why would anyone invest in somethingfor the long-term if it offers lower gains than what they could earn onshort-term investments?
One reason for this might be investors expect long-termyields to drop even lower and they want to get their foot in the door beforethose yields plunge even lower (again, no guarantee they will). In economicterms, lower long-term yields in comparison to short-term shields can mean thata recession is likely coming soon, or at least economic growth may slow down inthe coming months (which could further depress yields on maturities).
Just before the last seven recessions in the U.S. economy,the yield curve – specifically the 2-year/10-year version – inverted, with thelast time being 2007/2008. The Federal Reserve typically monitors the 3-month/10-yearyield curve to assess the likelihood of impending economic recessions, but bondinvestors largely prefer the 2-year/10-year yield curve as their key benchmarkfor determining whether or not a recession is coming soon.
Is There Another ‘GreatRecession’ Upon Us?
It’s already extremely difficult to predict economicactivity that hasn’t happened yet; making frantic investment decisions based onwhether or not a certain yield curve is flattening or inverting is likely apoor strategic move. Furthermore, trying to time the markets is trickybusiness; many investors in the past have bailed too early and missed out on tremendousgains while attempting to avoid the consequences of a potential economic downturn.
Just look back to 2007-2009 and imagine what financialposition you’d be in today if you sold a majority of your investments in themidst of the markets’ downward spiral. You likely wouldn’t have benefited fromthe massive gains that have occurred since then, so battening down the hatchesand ridingout the storm until the markets bounce back – as they always have – islikely preferable to jumping ship now simply because the yield curve invertedfor just one day in August.
Markets are inherently cyclical; your best strategy moving forward would be to hold steady, ensure you have an adequate emergency savings (so you don’t have to withdraw from your portfolio out of financial necessity) and invest in stocks, mutual funds, and bonds when the markets ultimately do go down so you can take advantage of the substantial gains potential when the markets bounce back.
An inverted yield curve means the interest rate on long-term bonds is lower than the interest rate on short-term bonds. This is often seen as a bad sign for the economy.
A yield curve inverts when long-term interest rates drop below short-term rates, indicating that investors are moving money away from short-term bonds and into long-term ones. This suggests that the market as a whole is becoming more pessimistic about the economic prospects for the near future.
In financial markets, the slope of the yield curve (e.g. normal, inverted, flat) provides an important signal of investors' expectations for future interest rates, and by extension their expectations for future economic growth and inflation.
So as the yield curve inverts, this damages their profitability, where they're paying out more and receiving like the same or less. So an inversion, no matter how it's structured, hurts the banks' profitability.
In normal circ*mstances, long-term investments have higher yields; because investors are risking their money for longer periods of time, they are rewarded with higher payouts. An inverted curve eliminates the risk premium for long-term investments, allowing investors to get better returns with short-term investments.
One explanation for why an inverted yield curve is a bad sign for the economy is straightforward and mathematical. “Primarily, it's because it slows bank lending activities,” says Stovall. “Banks make money by borrowing short and lending long,” he says.
Researchers at the New York Federal Reserve have found that an inverted yield curve has historically been a good recession predictor going back to the 1950s. As of January 2023, the New York Fed model gave a 60% chance of a U.S. recession on a 12-month view.
An inverted yield curve indicates that most investors believe interest rates will; decrease. If the nominal interest rate is 8% and the expected inflation rate is 3%, what is the approximate real rate of interest?
An inverted yield curve indicates that investors will tolerate low rates now if they believe rates are going to fall even lower later on. So, investors expect lower inflation rates, and interest rates, in the future.
A yield curve is a way to measure bond investors' feelings about risk, and can have a tremendous impact on the returns you receive on your investments. And if you understand how it works and how to interpret it, a yield curve can even be used to help gauge the direction of the economy.
What Is a Yield Curve? A yield curve is a line that plots yields, or interest rates, of bonds that have equal credit quality but differing maturity dates. The slope of the yield curve can predict future interest rate changes and economic activity.
The steepness and direction of the yield curve are used to gauge future interest rate changes and the general health of the economy. There are a few types of yield curves, but the most important are normal, flat and inverted.
The part of the Treasury yield curve that plots two-year and 10-year yields has been continuously inverted - meaning that short-term bonds yield more than longer ones - since early July 2022. That exceeds a record 624 day inversion in 1978, Deutsche Bank said in a note on Thursday.
In an inverted yield curve environment, investors face the question of whether it is a better strategy to take advantage of nominally higher interest rates by investing in short-term securities, but running the risk of reinvestment at worse conditions, or to lock in a lower yield for a longer period.
The yield curve helps indicate the tradeoff between maturity and yield. If the yield curve is upward sloping, then to increase his yield, the investor must invest in longer-term securities, which will mean more risk.
As we've outlined, an inverted yield curve could signal a slowdown in US economic growth, meaning lower inflation and likely cuts to interest rates. If you read that the yield curve has inverted, it might be worth consulting a professional financial adviser to discuss how your assets are invested.
The current inverted yield curve tells us what investors think will happen to the economy in the future: The Fed will need to cut interest rates because of a recession. However, when the yield curve inverts, it's not always an indicator of an economic downturn—even if it has been in the past.
With one exception, the inverted yield curve has signaled every recession since 1955. When the 2-year Treasury yield eclipsed the 10-year Treasury yield on July 5, 2022, it caught many investors' attention.
Introduction: My name is Van Hayes, I am a thankful, friendly, smiling, calm, powerful, fine, enthusiastic person who loves writing and wants to share my knowledge and understanding with you.
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