Recession Signals Light Up as Section of US ‘Yield Curve’ Inverts”-Yahoo Finance1
“5-Year and 30-Year Treasury Yields invert for the first time since 2006, fueling recession fears”-CNBC2
“Longer dated Treasury yields fall, briefly inverting curve, as investors factor in a more pessimistic outlook”- MarketWatch3
These are just a few of the headlines that you will see if you type “yield curve inversion” into your preferred search engine. The term yield curve inversion has received a lot of airtime on financial networks of late. There are several strategists that have you believe that with an inversion of the yield curve, it is a foregone conclusion that a recession is imminent. On the other hand, there are strategists that suggest that this time is different, and that the recent inversion does not predict recession. We believe it is important to provide our readers with a bit of context around this complicated subject in a manner that is easily understood.
Let’s begin by defining what the yield curve is and what purpose it serves. In its simplest form, the yield curve is a graphical representation of expected returns from bonds of different maturities. Strategists tend to look to the yield curve as an indicator of economic strength or weakness. For instance, a normal shaped yield curve will have lower expected returns for shorter maturities and higher expected returns for longer maturities. This scenario typically indicates times of economic strength.
By contrast, an inverted yield curve occurs when expected returns on shorter maturities are higher than expected returns on longer maturities. This scenario has been historically tied to weaker economic times. Several popular spreads that investors look at are the difference between the 10-year treasury and 2-year treasury (2/10 spread), the difference between the 30-year treasury and 5-year treasury (5/30 spread), and lastly the difference between the 10-year treasury and 3-month treasury. The two former spreads have inverted as of March 30th, 2022, however the latter is far from inverting.
As mentioned, each strategist will have a preferred spread that he or she monitors, but the story is consistent; historically, a yield curve inversion is a leading indicator for an upcoming recession. The theory behind this is that investors generally demand a premium for purchasing longer term maturities, therefore when that premium is no longer required, and safety of principal matters most, it sends a “risk-off” tone to the market. There are several caveats and additional data points to consider, for instance the magnitude of the inversion and the length of time the curve is inverted. Even though history suggests that yield curve inversion is a leading indicator of recession, there is generally a 12-24 month time lag before a recession begins.
This time is different:
In the other camp, there are investors who proclaim “this time is different”. Some analysts say that the Treasury yield curve has been distorted by the Fed’s massive bond purchases, which are holding down long-dated yields relative to shorter-dated ones4. There is also the view that due to the abundance of negative yielding debt in the world, foreign investors are turning to the U.S. Treasuries for the potential to earn a positive return; this also holds down the longer end of the yield curve. Both of which argue that it is not fear driving the shape of the yield curve, but rather exogenous factors.
The only sensible conclusion that we draw from this is that each scenario seems plausible and should be considered as a possible outcome. To that end, we are aware that a recession is possible within the next 12-24 months, but we shouldn’t adjust portfolios in a way that suggests that this is the base case. Two things we know for certain are, 1) recessions come and go and 2) market timing is impossible. We prefer to stick with a core asset allocation that aligns with our clients’ risk tolerance and stated objectives, occasionally making small changes at the margin.
If you have concerns about your portfolio, or if you would like to discuss this topic in more detail, please do not hesitate to give our team a call.