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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.
What Happens When theYield Curve Inverts?
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).
Graph Source – Market Watch
Why Are InvestorsConcerned?
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.
