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Personal Finance

Should You Worry About An Inverted Yield Curve?

2019-11-19

By Bob Landry, CFA, CFP®, Senior Relationship Manager

With financial and mainstream outlets reporting on recession fears amid reports of an inverted yield curve, many are wondering what it indicates about the health of the U.S. economy and stock market. Does an inverted yield curve provide valuable information about future stock premiums?

Read more about how investors can always find reasons to worry, and why learning to tune out the noise dramatically increases your probability of a successful financial plan.

 

Should You Worry About An Inverted Yield Curve?

The financial media (and increasingly the popular media) have reported in recent months about the inversion of the U.S. Treasury yield curve, and what it indicates about the health of the U.S. economy and stock market.

The Treasury yield curve is simply a graph of the current yield of U.S. Treasury securities at various maturities. Most of the time, the curve is upward sloping, meaning yields gradually rise on longer-dated maturities. Investors typically require a higher rate as a premium to compensate for the greater risk of unanticipated inflation because inflation erodes the value of fixed payments that most bonds provide. An inverted yield curve occurs when short-term rates exceed long-term rates. Two popular yield curve spreads monitored by investors are the difference between the 10-year Treasury note and either the 3-month Treasury bill or the 2-year Treasury note.

An inversion of the 10-year/2-year curve has predicted each of the past nine U.S. recessions since 1955, including the most recent that occurred between late-2007 and mid-2009 (“The Great Recession”). Therefore, the curve’s recent inversion has garnered much attention as concern about an imminent economic recession grows. Despite this excellent track record, predicting when a recession occurs after an inversion has taken place is no easy task. The timing is very uncertain. In September 1980, the lag was only ten months, while in June 1998, it was 33 months. The average was 16 months. This highly variable lag between initial inversion and the onset of recession makes this indicator a quite unreliable tool to predict when economic contraction will occur.

Since recessionary periods are not normally associated with a rising stock market, a key question is what an inverted yield curve means for investors. Does an inverted yield curve provide valuable information about future stock premiums (i.e., the return of stocks in excess of the rate available on risk-free T-bills)?

A July 2019 study from Nobel laureate Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College, “Inverted Yield Curves and Expected Stock Returns,” provides some helpful guidance. Fama and French compared six different yield curve spreads, switching from stocks to T-bills when any of the curves inverted. They then looked over the next one-, two-, three-, and five-year periods to assess the results of switching back and forth between stocks and T-bills. The researchers looked at data from 1975-2018 across the U.S. and 11 major stock and bond markets. The results? There was no evidence that inverted yield curves predict stocks will underperform T-bills over all of the periods tested.

Even though an inverted yield curve has historically served as a reliable recession indicator, research suggests making significant shifts to your asset allocation in preparation is unlikely to add value.

Investors can always find reasons to worry: the potential impact of trade wars, geopolitical events, and poor economic data, to name several recent examples. The ability to tune out the noise of the market dramatically increases the probability of success for your financial plan. This is why working with a Relationship Manager at AAFMAA Wealth Management & Trust provides value. We help you stay focused on your goals, manage your emotions, avoid potential mistakes, and continually track your portfolio to the appropriate risk level.

For a complimentary portfolio review, please contact us at wealthmanagement@aafmaa.com or call us at (910) 390-1425.