Breaking the Code: Inverted Yield Curve
By: Jeffrey Krueger, CPA, MSA, CFP®
Over the past several months, there has been a lot of talk in the news over the inverted yield curve. So what is it, exactly? A yield curve is a visual way to view the yield of equal credit quality fixed-interest securities (typically US Treasury securities) against the length of time they have to run to maturity. Typically, the yield curve is upward sloping, a sign that the economy is functioning properly. In this instance, as an investor, the longer you commit funds, the more you should be rewarded for the longer commitment and increased risk. A simplified example: say you have a friend who needs to borrow $100 and they say they’ll pay you back in a week. You may be inclined to lend them that money. If instead, your friend asks to borrow $100 and says they’ll pay you back in 10 years, you may have some additional thoughts as to whether your paths will cross a decade from now, let alone if your friend remembers to pay. Thus, you may charge a higher rate in the second option to be compensated for the added risk.
There are times, however, when the curve’s shape deviates from the normal upward slope. This seems counterintuitive as it would mean long-term investors are settling for lower returns than short-term investors, yet long-term investors are assuming more risk. The reasoning an investor might do that is if they believe rates will fall lower or are really concerned about the near-term, and thus want to lock in the current rate.
So, what happens if there is an inverted yield curve? Well if you are a lender, you are disinclined to lend money over a longer duration since the return is too low relative to the short term. Therefore, you will likely tighten up lending standards and only lend long-term to the most creditworthy people, while instead preferring to lend shorter term loans that have less risk and provide a similar/better interest rate.
Unfortunately, borrowers are less motivated to borrow capital short-term. With similar interest rates, a rational borrower would rather borrow at the same rate (or less) for a longer time period. This conflict tends to result in consumers hoarding cash and not investing. As lenders get squeezed paying higher short-term deposit rates and earning a lower interest rate on their loans, credit standards continue to increase and less borrowing and investing occur.
This downward cycle can lead to a downturn in the economy and, at times, a recession. Although an inverted yield curve does not guarantee the U.S. economy will go into a recession, every recession over the last 50 years has been preceded by an inverted yield curve. Note that there can be a lag, sometimes up to two years, before the slowdown arrives. It should also be pointed out that the yield curve is only one piece of a larger economic puzzle, along with the usual caveat that “past performance is no guarantee of future results.”
Whether the inverted yield curve signals an economic downturn or ends up being brushed aside, there are some positive items to consider:
Refinance your mortgage: As long-term interest rates plummet, so do mortgage rates. Mortgage rates are close to 5-year lows. If you haven’t refinanced in the last year, it may be a good time to review.
Take advantage of short-term savings rates: As short-term rates rise, many high yield savings accounts are paying +2%. These are some of the best rates we’ve seen in a long time to optimize your cash.
Income-producing assets may increase in value: As long-term interest rates decrease, it becomes harder to generate the same amount of income with the same capital. For example, a rental property generating $40,000 a year in profit would be equivalent to a $1,000,000 position at a 4% rate of return. If you can only generate a 2.5% rate of return, you would need a position of $1,600,000 to replicate the income.
Review asset allocation: Now is likely a good time to revisit your risk tolerance with your trusted advisors. How would you feel if there was a significant drop (+20%) in your portfolio? Similarly, certain sectors have performed better over the last decade than others. A good advisor will have monitored and rebalanced, but it doesn’t hurt to check that it aligns with your preferred allocation.
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