Astute investors focus in on the bond market yield curve.
By Judson Ames
In assessing the market selloff this week the casual investor was likely focusing on the headlines surrounding the potential for escalating “trade-war” between the U.S. and China, however, the more astute investors are starting to focus in on the shape of the bond market yield [rate] curve as evidenced by media headlines such as:
Before we go any further in explaining the importance of the yield curve, if you only take away one thing from this article understand this one point key regarding the importance of paying attention to the bond market yield curve!
KEY POINT: The “yield curve” refers to a graphical representation of interest by maturity. When the 2-Year to 10-Year US Treasury Bond Market Yield [rate] Curve inverts [e.g. when short-term interest rates are higher than long-term interest rates] it is seen as being a strong indicator that a recession “may” occur within 2-years. In fact, an INVERTED 2-Year to 10-Year Treasury Yield Curve has correctly predicted the last six recessions and as we all know historically recessions have coincided with below average investment returns.
*Shaded areas indicate periods U.S. was in a recession.
So was there a “big yield curve inversion”? NO. The 2-Year to 10-Year US Treasury Bond Market Yield Curve is not “inverted, rather only a small portion of the curve is inverted as seen in Figure 2. (But kudos to the fear mongering media for clicking astute readers to click on their story!)
Now that we have discussed the basics of why punditry are now discussing the yield curve let’s back up and define what a “normal” yield curve look like, to begin with, and then move on to why the yield curve inverts, and what it means for your investments.
A “Normal” Bond Yield Curve Defined
Just as our body temperature is optimal around 98.6°F (37°C), there’s a preferred equilibrium between bond market terms and yields. “Normal” occurs when short-term bonds are yielding less than their longer-term counterparts. Under normal economic conditions, investors expect to be compensated with a term premium for taking the incremental risk of owning longer maturities. They’re accepting more uncertainty about how current prices will compare to future possibilities. Conversely, they’ll accept lower rates for shorter-term instruments, offering greater certainty.
At the same time, evidence suggests there’s often a law of diminishing returns at play. Typically, the further out you go on the yield curve, the less extra yield is available. Thus, Figure 1 depicts a relatively normal yield curve, with a bigger jump to higher returns early in the curve (a steeper spread) and a more gradual ascent (narrower spread) as you move outward in time.
Variations on the Curve
Figure 1 depicts a normal yield curve, what happens when things aren’t so normal, which is so often the case in our fast-moving markets? Figure 2 depicts three different curve shapes that can result when markets aren’t “normal”. The blue line representing the U.S. Treasury Yield Curve as of December 4th according to the U.S. Treasury Department.
The shape of the yield curve essentially reflects evolving investor sentiments
about unfolding economic conditions.
In short, expectations theory suggests that the yield curve reflects investor expectations of future interest rates at any given point in time. Thus, if investors in aggregate expect rates to rise (fall), the yield curve will slope upward (downward). If they expect rates to remain unchanged, it will be flat.
You, the Yield Curve and Your Investments
It’s rare for the yield curve to invert, with long-term yields dropping lower than short-term. But it happens. This typically is the result of the Federal Reserve (or another country’s central bank) tightening monetary policy, i.e., driving up short-term rates to fight inflation. An inverted yield curve is often followed by a recession – although not always, and not always universally.
As we noted above the yield curve is NOT inverted, so if the yield curve is not “inverted” what’s all the hoopla about? Why did media punditry imply the yield curve shape was responsible for some of selling on Tuesday and Thursday? (Remember the market was closed on Wednesday). Essentially what they were alluding to was that the astute investor was becoming more cognizant of the fact that yield curve is “close” becoming inverted. How close is it? The difference between the 2-year rate and the 10-year Treasury Bond rate, which know as the yield spread, has fallen to 0.18%. Indeed a difference of less than 0.20% is a cause for concern as was noted in DHW’s 2nd Quarter Commentary.
Does this mean you should head for the hills? No! If the yield curve inverts or takes on other “abnormal” shapes, should make significant changes in your investment allocations? No! At least not in reaction to this single economic indicator.
As with any indicator, the yield curve should be utilized as one tool, but should not be utilized in isolation to make wholesale changes investment allocation. What DHW does is look at what the yield curve is telling us and combine that information with what we are seeing in other market-based indicators to decide if we need make slight tactical adjustments to our client’s allocations.
As with any other data source, bond yield curves are best employed to inform and sustain your durable, evidence-based investment plans, rather than to tempt you into abandoning those plans every time bond rates make a move. Big picture, this typically means investing in bonds that offer the highest yield for the least amount of term, credit and call risk. (Call risk is realized if the bond issuer “calls” or pays off their bond before it matures, which usually forces the bond’s investors to accept lower rates if they want to remain invested in the bond market.)
In summary, in my opinion, the current shape of the yield curve is NOT telling us to “run for the hills” as media headlines would seem to suggest, but rather it is telling us to vigilant!
Remember, the media’s objective is to get “clicks” in order to sell advertising. They know fear sells and consequently, I would suggest investors not focus on financial media headlines! This is a warning for those that do because experience has taught me that fear-based decisions can lead to costly mistakes!
Disclosure: All written content is for information purposes only. It is not intended to provide any tax or legal advice or provide the basis for any financial decisions. Please consult your investment professional before making an investment decision based on the material cover herein. The information contained herein is not an offer to sell or a solicitation of an offer to buy Dark Horse Wealth LLC s