There’s been a lot of media attention on the Treasury Yield Curve lately. And with good reason: a change in its shape is often one of the first visible signs of trouble to come for the economy. Because stock performance is related to economic performance, many investors look for any indicators of the health of the economy. The shape of the Treasury Yield Curve is perhaps the most widely-watched one.
What is the Treasury yield curve?
Every month, the U.S. Treasury issues bonds with maturities from one month to thirty years and sometimes even longer. U.S. Treasury bonds are considered risk free (backed by the full faith and credit of the U.S. Government), and so their yield is a clear indicator of the lowest rate of return investors are willing to accept for an investment of a given maturity.
Under normal conditions (see the blue line from January 2016 in the attached graphic), investors will demand higher returns (higher yields) for money invested over a long time than they will for money invested over a shorter time. This is one reason bank CDs offer higher returns for five years than for 12 months. In fact, a bank CD typically offers more yield than a savings account which can be withdrawn any time. Longer-term investments usually offer higher returns.
Why does the yield curve invert?
An inverted yield curve means that investors are demanding higher returns for short-term investments than for long-term investments. Said another way, they are willing to accept lower long-term yields because they believe the economy will do poorly in the near-term.
This will be most obvious looking at the difference between bonds maturing in less than one year compared to those maturing in 10 or 20 years. The red line in the graphic shows the Treasury Yield Curve from November 2006. At the time, investors were becoming nervous about the state of the housing market and the economy in general.
According to Bloomberg Intelligence, an inverted Treasury Yield Curve has accurately predicted every recession for the past 40 years. Since the stock market tends to sell off before recessions begin, it’s easy to see why investors are so interested in where the economy is heading. The challenge is that the yield curve inversion can happen many months before economic conditions actually worsen. In this example from 2006, the curve first inverted in August 2006, sixteen months before the recession began and about fourteen months before the stock market sold off. It may be an accurate indicator, but it isn’t very timely.
What is the Treasury yield curve telling us today?
The green line in the chart (from August 21, 2018) shows a curve that is a lot “flatter” than just a couple of years ago. Flattening means that long term bonds are still yielding more than short term bonds, but that the difference between the two is getting very small. A flat yield curve can persist for years, and there’s no telling when it may ever become inverted. So while today’s flattening shape suggests that investors are becoming nervous about conditions, the actual timing of an upcoming market sell-off or recession is not at all clear. Even if the curve heels over into an inversion, it wouldn’t mean you need to take cover immediately- the average lead time from inversion to recession is about 16 months. But it would mean to start thinking about how a recession might impact you and to prepare for some volatility in the months ahead.
One last word of caution
Few investors have historically been able to consistently time their buying and selling to be in the market for the good times while avoiding losses when it gets rough. Indicators like the yield curve are useful tools, but they are far from perfect.
As professional wealth managers, we do keep an eye on market indicators such as the shape of the yield curve. And we may make changes in the income portion of a portfolio based on the changing bond yields. However, we place far more emphasis on having a long term, disciplined approach than on making short term timing decisions. Our primary concern is assuring that a client’s investment portfolio is properly balanced and well-aligned with their vision of the future. And within that, assuring that the investments being used are of the highest quality, meaning that they are low cost, transparent, and highly liquid.
With a well-built and well-managed investment portfolio, it is not necessary to try and time the impact of worrisome indicators such as a flattening yield curve. Please contact us to learn more about our Investment philosophy and how it helps bring confidence, clarity and direction to your finances.