Inverted Roller Coaster

Inverted Roller Coaster

by Erin McMenemon on August 20, 2019 The Behavioral Investor

If you have seen the headlines in the news and the subsequent market reactions, you may be asking yourself what it all means…

  • Main yield curve inverts as 2-year yield tops 10-year rate, triggering recession warning” CNBC
  • Recession watch: What is an ‘inverted yield curve’ and why does it matter?” Washington Post
  • “Bonds Signal Growing Global Distress After Key Yield Curve Flips” Bloomberg
  • “Warning Signs Point to a Global Slowdown” Wall Street Journal

 The yield curve is important, but what do these headline interest rates mean and what drives these numbers?

The yield curve is the difference (or spread) between the interest rate (yield) on the 10-year Treasury bond and the yield on a shorter-term Treasury bond—for example, the 3-month or the 2-year. A normal yield curve has longer-term bonds paying more than shorter-term bonds, meaning you are being paid more to loan your money to the U.S Treasury for longer times (this makes sense when future looks promising). A little deeper—the 10-year Treasury is a signal of investor confidence in the future economy. When investors perceive the future to be worse there is a flight to safety in short-term bonds (increased demand).

Today, shorter-term bond yields are larger than longer-term ones, an experience known as an inverted yield curve. Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve. This comes with a caveat however that there is a lag between this inversion and the actual start of a recession.

Today, while economic growth is slowing, the labor market remains strong. So, people are also questioning what this signal means. Historical data indicates that, in the near-term, markets tend to rise initially after an inverted yield curve occurs. This is because short-term yields often rise above longer-term yields well before the economy shows signs of significantly slowing down. All of which begs the question—will the yield curve’s historic role in warning for future recessions apply to current circumstances? We believe it does.

At BCM, we are following the yield curves in our analysis of the economy and markets. This is one piece of the picture and the information we have looks at more than just this one (albeit important) indicator of future recessions. A yield curve that remains inverted for an extended period of time (several weeks at least) tells us that the likelihood of an impending recession is rising. It does not however indicate exactly when such a cyclical economic downturn will occur. If you look at the graph above, you can also see that there have been two inversions that did NOT result in a recession (1966 and 1998).

An inverted yield curve is a red flag but the signal is not perfect and it is not to be interpreted as the sole indicator for timing a recession. We are going to take it as a useful heads up that things could be changing in the financial world, and not necessarily for the better.

If a recession is in fact rolling in, stocks often begin to react adversely well before the recession arrives.  That’s where our BCM Market Risk Model has been most beneficial for our clients. Because it incorporates a number of leading economic indicators as well as current market dynamics, these inputs together can paint a cohesive picture of the market’s current risk climate. Since developed in 1986, BCM’s Market Risk Model has been most effective alerting us to potential financial trouble well in advance of a recession’s full negative brunt.

Please contact us with any questions you have, or interest in hearing more about our tactical and disciplined approach. We would love to help you prepare for your future as we continue to watch the red flags and act as our risk model directs.


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About the Author

Erin Despot McMenemon joined Billeaud Capital Management in 2016 as an Investment Adviser Representative. Erin has 11 years of experience in valuation and financial consulting, investment banking, and private portfolio management. Erin received her Masters of Business Administration degree from the A.B Freeman School of Business at Tulane University and holds a degree in Finance from Louisiana State University… Read more.