Investments

What is Yield Curve Inversion?

By Jason Newcomer

April 18, 2019

What is yield curve inversion? The harbinger of doom?

A recurring headline in financial media lately discusses something called the yield curve inversion. The yield curve has historically been a fairly accurate predictor of economic turmoil and recessions. In “normal” times, longer maturity bonds have higher yields than shorter maturity bonds. Rarely, the tables get turned, and longer maturity bonds actually have lower yields than shorter maturity bonds. This can be boiled down to supply and demand. So, what exactly is yield curve inversion?

“Now I am become death an inverted yield curve, the destroyer of worlds.” – J. Robert Oppenheimer

Brushing Up on Bonds

Firstly, a primer on bonds. Regarding bonds, price and yield have an inverse relationship, meaning when the price goes down, yields come up (think of a seesaw, with the price on one side, and the yield on the other).

Normal Yield Curve

For instance, let’s assume the mass investing public generally feels the economy will be doing well in over the next decade, and they want to participate in the stock market. They feel stocks will benefit from a prosperous economy. They sell their conservative bond investments, and as a result rush into stocks. Demand for bonds goes down across the board, consequently sending the price of those bonds down with it. When the price drops, yield goes up. When long-term yields are higher than short-term yields, you have a normal yield curve, something that looks like this:

Source: https://en.wikipedia.org/wiki/Yield_curve

Yield Curve Inversion

Next, let’s look at how a yield curve inversion happens. The mass investing public feels that the economy will struggle, and therefore possibly go through a recession in the future. No one wants to be the last one out of a burning room, so everyone sells their stocks. That money has to go somewhere, and as a result a safe place to park that money is US treasury bonds. There is now a greater demand for bonds since everyone wants in. When demand increases and supply remains constant, the price will increase. Think back to the seesaw. The price of bonds has gone up, so yields have come down. Our yield curve now looks something like this:

What’s the Big Deal?

So, what is the big deal about yield curve inversion? Is it a bad thing? Does it mean certain turmoil is around the corner? Let’s look at when this has happened in the past.

Source: Pension Partners – https://pensionpartners.com/inverted-yield-curves-and-recessions/

In the last 60 or so years, the economy has entered into a recession following the point in time when the yield on 10-year treasuries falls below the yield on 1-year treasuries. Similarly, let’s take a look at where yields on 1-year and 10-year treasuries are as I’m writing this post.

Source: Treasury.gov – https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

Does this mean we are heading to another recession? Maybe. Maybe not. Does this mean you need to get out of the stock market before the next crash happens? Let’s take a more pragmatic approach.

Take a look at your investment allocation. What does your allocation look like? What percentage of your investments are in stocks or stock funds, or are highly correlated to stocks? What’s your hedge against stocks? How would a bear market in the stock market impact your financial goals, both in the short-term and long-term?

Planning is Key

By the time we got through the last economic recession in the US, the stock market had been drawn down by more than 50%. Even a moderate portfolio made up of 60% US stocks and 40% US bonds experienced a drawdown of about 30%. The market eventually did recover and go on to new highs, as did the hypothetical moderate portfolio. If the next recession brings along a bear market for stocks, are you going to be able to ride out the storm (emotionally, mentally)? How does changing your allocation before the next bear market impact those financial goals?

In conclusion, this is where having a financial plan, and the process of planning and revising, can have a massively positive impact. If you can’t answer those questions on your own, you should be working with a financial planner.

If you are ready to start your financial plan, or simply want to review your current plan, we’re happy to help. Barber Financial Group provides no-obligation consultations with our financial planners. They will sit down and discuss all of your options and help guide you toward your one best financial life. Fill out the form below or call us at 913-393-1000 to start your journey to and through retirement.

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Investment advisory services offered through Barber Financial Group, Inc., an SEC Registered Investment Adviser.

The views expressed represent the opinion of Barber Financial Group an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Barber Financial Group does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.