On Tuesday, August 27, the yield on the 10-year Treasury note fell below the 2-year Treasury rate, resulting in an inverted yield curve.
This is a big deal because the bond market is a key indicator of economic health.
When returns on long-term bonds (10-year Treasuries) fall below short-term bonds (2-year Treasuries), it generally signals that investors are concerned about a slowing economy and are increasingly focused on near-term economic conditions.
And while parts of the curve have inverted in recent weeks, the 2- and 10-year spread — spread is the yield difference between the two — has not inverted in 14 years.
Yield curves
First, some perspective on how a yield curve is typically shaped.
A “normal” yield curve slopes upward, with short-term rates lower than longer-term rates.
This is because investors generally demand a premium to hold debt for longer periods of time — they are taking on more risk after-all.
An inverted yield curve seems counterintuitive then. Why would long-term investors settle for lower rewards than short-term investors, who are assuming less risk?
The answer: long-term investors believe that this is their last chance to lock in current rates before they fall even lower.
To quote a colleague of mine, would you rather eat lobster today or save for 10 years and eat shrimp instead?
The image below is a real-world example of what yield curves can look like. The yield curve on 8/22/2018 was normal, with long-term rates higher than short-term. More recently, the yield curves are increasingly inverting.
Risk of an inverted curve
As you might expect, since lower interest rates generally mean slower economic growth, an inverted yield curve is often taken as a sign that the economy may soon stagnate.
While the past is not a predictor of the future, the reason an inverted yield curve unnerves many investors is that it has historically been a predictor of a recession.
In fact, an inverted Treasury yield curve has preceded all nine US recessions since 1955, according to a study conducted by the Federal Reserve Bank of San Francisco.1
should you be worried?
Regardless, predicting a recession from past events isn’t foolproof and a yield curve inversion does not necessarily mean imminent doom for the stock market.
Even the New York Fed has noted that by even the most aggressive predictions, a recession is at least 12 months out.2 And, after the inversion of the 2- and 10-year spread in December 2005, the S&P 500 rallied for nearly two more years, peaking in October 2007.
But what can you do to protect yourself in the event of an economic downturn?
There are two things that you should be doing now to hedge against a recession and they both revolve around your cash flow: 1) make yourself indispensable to your employer and 2) have enough cash on hand in case you do lose a job.
As far as investments go, tune out the noise and remain focused on your long-term financial goals. Market volatility is no reason to abandon your investment strategy.
In fact, when markets are down, it’s a great time to increase contributions and take advantage of purchasing assets while they’re cheap!
1. Federal Reserve Bank of San Francisco, “Economic Forecasts with the Yield Curve,” March 5, 2018, www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve
2. Federal Reserve Bank of New York, “Probability of US Recession Predicted by Treasury Spread,” August 2, 2019, https://www.newyorkfed.org/medialibrary/media/research/capital_markets/Prob_Rec.pdf?mod=article_inline
