Dear Clients & Friends,
There has been a lot of talk recently about “the yield curve” and, more specifically, an “inverted” yield curve. News pundits say that an inversion is very, very bad -but they don’t explain why very often, likely because the concept is perceived as being too daunting and complicated for the average viewer’s understanding. So, I am going to exercise my talent in simplifying complex topics and explain this in a way that non-financers can understand. Here we go.
Everyone knows that when dealing with anything related to debt and interest rates, the rate of interest generally increases along with the duration of the loan. A 30-year mortgage has a higher interest rate than a 15-year mortgage. A 5-year car loan has a higher interest rate than a 3-year car loan. Because the bank accepts more risk by lending money for a longer period of time, the bank demands a higher interest payment to compensate them for the increased risk. The same concept works in reverse. A 3-year CD pays a higher interest rate then a 1-year CD because the investor is taking on more risk by locking up their money for a longer period of time; therefore, the increased risk demands a higher rate of return.
With this logic, one would assume that a 30-year Treasury bond would pay an investor a higher interest rate than a 2-year Treasury bond, just like in the CD example above. It usually does, but it doesn’t right now, and that’s really, really bad! Here’s why.
As we discussed above, the risk increases along with the duration of a loan or investment; thus, the interest rate generally increases along with the length of time. When a short-term bond pays a higher rate of return than a long-term bond, one can make the assumption that people believe the short-term bond to be riskier than the long-term bond. This seems backwards. Historically speaking, over the long haul, economies grow and markets go up over time. So, if investors as a whole are more concerned with the short run, we must assume that investors as a whole are expecting some kind of a major disruption in the short run.
United States Treasury bonds are considered by most domestic and foreign experts to be the most liquid investment in the world. Additionally, every developed country owns US Treasury bonds in their National Treasury reserves, which makes the Treasury bond ownership audience the largest audience of investors in the world. Because of these two characteristics, movements in Treasury bond yields have extremely dramatic effects on a global level. This is why experts pay such close attention to the human behavior that affects US Treasury yields.
Inverted Treasury yields have preceded all of the last nine US recessions. That’s why everyone is yelling about Treasury yields, because right now, they are inverted.
I should point out that yields have inverted long before recessions have set in. Prior to the 2008 recession, treasury yields inverted in 2006. They inverted again in late 2007, which was extremely alarming and led us into a recession. But it’s important to note that it can take time for the markets to fall after Treasury yields first invert.
In addition, inverted Treasury yields are not scientifically correlated to a failing economy. Inverted yields illustrate that the global community of investors has concerns. This particular concern regarding Treasury yields has proven to be historically accurate, but it’s an indirect correlation - not a direct correlation.
So… that’s what the term “inverted yields” means, and why it is concerning. Assuming that you have been keeping up with our articles, you know that we have been expecting a good 2019 and a challenging 2020. We don’t know exactly when the last shoe will drop, but we do know that inverted yields are, at best, a scary reality.
That being said, let us end with happy thoughts. We don’t think that a recession will be upon us this coming week. Therefore, we wish all of you a wonderful Sunday afternoon.
Matthew Ramer, AIF® Principal, Financial Advisor MOR Wealth Management, LLC
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