The yield curve refers to the relationship between the short- and long-term interest rates of bonds issued by the U.S. treasury. An inverted yield curve occurs when short-term interest rates exceed long-term rates. Typically, this occurs when the 2-Year U.S. Treasuries are paying more than 10-Years U.S. Treasuries1
Last week the yield curve inverted for the first time since August 2019. For a moment, investors were faced with the choice to get paid a lower interest rate to lock their money up for eight extra years.
Typically, the interest rate on bonds are higher the longer you go out in time. Which makes sense because you assume more risk if you loan your money out for a longer period. And if you take on more risk you want a higher return.
Right now, short-term rates are going higher as traders prepare for rate hikes. Longer term rates aren’t rising as fast, which could potentially signal investors expect rate hikes will slow down the economy.
These rates are important for those investing in bonds, taking out a mortgage, applying for a personal loan and more.
However, the shape of the yield curve is arguably more important as an economic indicator. This is because the shape of the yield curve tells us about the health of the economy and where we might be in the business cycle.
This has gained a lot of attention because in past economic cycles the “inversion” has been a reliable signal that a U.S. recession was on the way.
Of the six recessions since the early 1980s, some form of yield curve inversion occurred anywhere from 9 to 23 months before, during which the market performed well.
Should You Sell?
I’m always skeptical when people assume they have a magical signal that will tell them exactly when to sell or buy in the markets.
The inversion signal has always been hard for investors to get behind because it has given such a long early warning.
If you look at the last four yield curve inversions, the market returned 28.8% on average and didn’t peak for another 17 months.
This data suggests that investors can miss out on meaningful upside by shifting to cash after the initial inversion.
I would not recommend making tactical changes based on the yield curve. For example, if you had cashed out of U.S. stocks following the most recent yield curve inversion (August 2019), you would have missed out on a 67% total return.2
A recession is always possible and, in the longer-term, is inevitable. But trying to predict the exact timing is a losing strategy.
The best thing investors can do is make sure to have a game plan in mind for the possibility of a recession, no matter the reason for it.
Sources and Disclaimers:
1Yield Curve Definition from Investopedia
2Total return from 8/27/2019 – 4/5/2022 data from YCharts
Yield Curve Inversions Can Be Bullish for Stocks from LPL Research
Yield Curve Steepness Chart from Clearnomics
2-year Treasury yield tops 10-year rate, a ‘yield curve’ inversion that could signal a recession from CNBC
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