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Is the Yield Curve Inversion a Cause for Alarm?
Dec 7, 2018 at 03:03 PM
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The Quick Facts

  • The yield curve is a plot that shows bond yields for different maturities on a single graph. The left end of the yield curve shows the Fed's overnight interest rate, and the right end shows the interest rate on a 30-year bond.
  • In most cases, long-term interest rates are higher than short-term interest rates. For example, it usually costs more to borrow money for a decade than it does to borrow money for one year. As a result, the slope of the yield curve is usually upwards.
  • A steep upwards slope can indicate that investors expect inflation and interest rates to rise in the future. This often happens when the U.S. is coming out of a recession.
  • A flatter slope indicates that investors expect slower growth and inflation in the future.
  • A negative slope often indicates that a recession is approaching, and the Fed will have to lower interest rates. An inverted yield curve preceded the dot-com bubble and the 2008 financial crisis.
  • This week, the yield curve experienced its first inversion since 2007, when parts of the front end of the curve flipped to a negative slope.

Food For Thought

Does the yield curve inversion signal an approaching recession?

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Bloomberg Opinion

Market Moves Suggest a Recession Is Unavoidable

Jared Dillian
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Our Commentary

This opinion from Bloomberg's Jared Dillian makes these kinds of assertions:

  • There are signs of market pessimism all around. On Wall Street, people don't seem to be eager to buy this stock market dip, fearing that another recession is around the corner. Even the Fed has signaled that "a pause in interest rate hikes may be coming."
  • The inversion of the yield curve is the strongest signal yet, because "everyone knows that inverted yield curves are the most reliable recession indicators." At least this time, "ample opportunity is being given to cut exposure to risk."
  • The inevitable recession isn't necessarily something that we need to fear. Down cycles in the economy are necessary because they have "cleansing properties, helping to right the wrong of billions of dollars allocated to bad businesses."

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Financial Times

What is the yield curve and why has it spooked investors?

Joe Rennison & Robin Wigglesworth
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Our Commentary

This Financial Times analysis from Joe Rennison & Robin Wigglesworth makes these sorts of points:

  • There's no such thing as a "market measure that could clearly communicate economic trouble ahead, without fail," but an inverted yield curve gets pretty close.
  • It's "unlikely" that a U.S. recession is "imminent," especially given the country's strong economic growth in the third quarter and positive growth data from the manufacturing sector. However, the yield curve is "a warning sign precisely because it tells investors about expectations for the future and not necessarily about the state of things right now."
  • On average, an economic recession lags about 21 months behind an inverted yield curve, and "an inverted yield curve has preceded every economic recession in the US since world war two."

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InvestorPlace

Does a Flattening Yield Curve Mean It’s Time to Sell? Not Yet.

Our Commentary

Luke Lango makes these types of points in his InvestorPlace opinion piece:

  • It's important to remember that only a portion of the yield curve inverted this week. The most important spread is the one between the 10-year Treasury yield and the 3-month Treasury yield, and this spread is still hovering around 50 basis points.
  • Based on past history, the 5-2 year spread typically inverts first, and is followed about 3 months later by the 10 year - 3 month inversion, and it's another 18 months before the market peaks. This means that there's still an opportunity for the market to "undergo a boom" while this all plays out.
  • The bottom line is that now isn't the time to sell stocks. The inverting yield curve is a "warning sign," but "the meaningful part of the yield curve still hasn't inverted." It is wise to be careful, but it's not time to panic.

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The Wall Street Journal

Afraid of the Yield Curve? You’re Looking at the Wrong One

James Mackintosh
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Our Commentary

This commentary from James Mackintosh in the Wall Street Journal makes these types of points:

  • People seem to be paying an inordinate amount of attention to the 5yr-2yr spread. Typically, this spread doesn't matter nearly as much as the 10yr-2yr spread (watched by markets), or the 10yr-3yr spread (watched by academics.)
  • The current yield curve makes it clear that investors think we are in the late phase of an economic cycle, but this should not come as a surprise to anybody. The curve doesn't tell us when this downturn could occur, and there's still an opportunity for stock market gains over the next year or so.
  • Investors should remember that "past experience is no guarantee of the future." The best advice right now is to "gradually shift to a more defensive stance as the economic cycle matures," but it's certainly not the time to panic.

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