Understanding The Inverted Yield Curve

Our economy is about to make history. June of 2019 marked 10 years of expansion of the U.S. economy, which ties with the previous record spanning March 1991 to March 2001.

Quarterly Commentary The inverted yield curve

The economy is on track to have its longest period of economic expansion in U.S. history, meaning that various measures of our country’s economic success are on an upward trend. June of 2019 marked 10 years of expansion of the U.S. economy, which ties with the previous record spanning March 1991 to March 2001. 10 years of expansion is nearly double the average expansion since the 1940’s.

This may leave an investor wondering if the end of growth may be near. However, economic expansions don’t simply die of old age. You can look to Australia’s economy, which has been growing for the past 28 straight years, as a good example.

What ultimately directs growth is the underlying health of the economy. Economic health is typically measured by factors such as employment levels, inflation, and gross domestic product (GDP). Unemployment is currently at multi-decade lows and inflation remains in check. Both are positive signs of a healthy U.S. economy.

Recently, attention has turned to the bond market, where the yield on longer-term U.S. Treasury bonds is lower than their short-term equivalents. This phenomenon—known as yield curve inversion—has received a fair amount of media coverage recently, and it’s often described as a sign that a recession could be coming.

Though an inverted yield curve has preceded a number of recent recessions, the timing around a recession is uncertain, often happening years later. Additionally, stocks can still have positive performance while the yield curve is inverted.

What is the yield curve, and why is it inverted?

The yield curve refers to the yield paid on bonds at different maturities. Bond maturity refers to the amount of time between when the bond is issued and when it reaches its end date and the issuer must redeem it. Generally, bonds with longer maturities have higher yields to compensate investors for tying up their money for longer. This is called an upward sloping yield curve.

Upward Sloping Yield Curve (US Treasuries—June, 2018—1 Year Ago)

Graph showing yield curve sloping upwardsData: US Treasury

The yield curve inverts when longer maturity bonds—10 year bonds for example—have a lower yield than short-term bonds. To describe the slope of the yield curve, yields on three-month or two-year maturity bonds are often compared to the yield on 10-year bonds. If three-month or two-year bonds have higher yields than the 10-year bonds, the yield curve is considered inverted.

Inverted Yield Curve (US Treasuries—June, 2019)

Graph showing inverted yield curve

Data: US Treasury

The yield curve generally inverts when investors collectively think that short-term interest rates will fall in the future. In that case, investors rush to “lock in” a rate for a longer period of time, and in the process, they drive down yields.

During recessions, the Federal Reserve generally lowers short-term interest rates to stimulate growth. In the past, an inverted yield curve has often preceded a recession as bond investors looked to lock in a rate for a longer time period in anticipation of actions taken by the Federal Reserve.

How predictive has the yield curve been?

To be fair, an inverted yield curve has preceded a number of recessions. However, an inverted yield curve does not make an upcoming recession a sure thing. In fact, three of the last 10 times that the yield curve inverted, no recession occurred over the following two-year window, per Goldman Sachs research in March of 2019.

Even in the times when a recession did follow, the timing has been fairly uncertain, starting anywhere from 8 to 22 months after the curve inverted. This lead time was often longer during periods of low inflation—like the current inflation environment, which has been hovering at or below 2% for a number of years now.

Finally, there just haven’t been enough historical business cycles to confidently say an inverted yield curve means a recession is coming. Business cycles represent the rise and fall of the economic output of goods and services and are generally measured by a country’s GDP. There have been 33 full cycles since the mid 1850’s, and only 11 in the modern, post-war era. With such few instances in the past to draw from, it’s hard to say that an inverted yield curve on its own means a recession is on its way.

What should an investor do?

Often, more money can be lost trying to avoid a down market than in the down market itself. In general, stocks have risen even as the yield curve was inverted. It’s also important to remember that a market decline of 10% or more has lasted four months, on average. Therefore, trying to time the next downturn generally isn’t a good strategy. Instead, investors should make sure that the risk in their portfolios matches their investing time horizon.

Smart investors align the risk in their portfolio to reflect how long they plan to invest. Money that you will need soon should skew towards lower risk investments. At Betterment, we’ll help you do this automatically by setting your portfolio up at an appropriate allocation (your mix of stocks and bonds) and with auto-adjust turned on in your portfolio, we’ll automatically adjust your allocation as your goal’s end date approaches.

Betterment’s portfolio recommendations take the potential for down markets into account and seek to align your risk with your investment horizon to help you have the best chance of reaching your goals—whether there is a recession in the future or not.