There’s been a lot of noise in the media about inverted yield curves and what they mean for the markets and the economy. While it’s true that inverted yield curves have generally preceded recessions, there are also misperceptions that could lead investors down the wrong path.
First, let’s recap some basics: The yield curve represents a market of rates from very short (overnight) rates to long (30 year) maturities. The yields of shorter-term bonds—aka the “short end” or “front end” of the curve—are most heavily influenced by Federal Reserve actions. As the Fed tightens, the yields of short-term securities tend to rise commensurately. At the same time, the yields of long-term bonds—aka the “long end” or “back end” of the curve—are influenced more heavily by the market’s longer-term view of economic growth and inflation.
Why does this matter? Most of the time the curve is positively sloped (long rates are higher than short rates). In this sort of environment, borrowing costs are generally lower than expected returns on investment. That makes borrowing money an attractive choice for a business. If short-term borrowing rates are 3% and a company has a return on invested capital of 5%, it’s profitable for that company to borrow and invest. This investment can take many forms: building new plants, spending on equipment, hiring more employees and acquiring other companies. All of these activities contribute to economic growth.
When the curve inverts, the opposite is true. If the cost of borrowing is greater than the expected return on capital, companies are more likely to curtail the activities I mentioned and instead focus on paying down debt. Over time and multiplied across companies, this contributes to slowing economic growth. At some point, economic slowdowns can tip into recession territory.
Banks and finance companies are also dependent on the slope of the yield curve. Banks are in the business of borrowing at lower rates and lending at higher rates. When the curve inverts, it lowers or eliminates the economic incentive for banks to lend to businesses and individuals alike. This can dry up available credit and slow the economy further.
So, if the yield curve inverts, should investors panic, rush to the sidelines and flip their asset allocations upside down? No, I don’t think so. An inverted yield curve is not a reason to re-write all the fundamental principles of long-term investing. It’s also not a switch that moves the economy from growth to recession overnight. Yield curves tend to change slowly. Yield curve inversion is a process, not an event. The yield curve has been flattening—that is, moving toward inversion—for many years now, and while pressures are building, the economy has kept going. Once the curve inverts, historically we have seen lags of months—and at times, more than a year—between inversion and recession.
Also, there are many factors that either help or hinder economic growth. What matters is how all the gears are working together. Right now, there are other positive factors that have to be balanced against an inverted curve—including tax reform, de-regulation and a patient Fed. (In a recent blog, our Global Chief Investment Officer also considers whether the shallowness of this current recovery could help sustain it.) Right now, the sum total of economic data and policy suggests that the U.S. economy is positioned to expand through the remainder of the year, if not longer.
So, if you shouldn’t panic about an inverted yield curve, should you ignore it entirely? That’s probably not the right approach either. Instead, this is a good opportunity to check in on your asset allocation—to rebalance and possibly enhance the diversification of your asset allocation. In my view, this is an environment that still offers plenty of opportunities, but risk management matters a lot at this stage of the economic cycle. Most importantly, you never want to be a forced seller. Review your liquidity needs now, so if the market does correct, you can see that volatility as an opportunity, not a problem.