If you keep up with financial news (an unhealthy practice, by the way), you’ve probably heard
tell of the dreaded flattening, or worse, inverting of the yield curve. An inversion
happened toward the end of 2019, just before the Covid Crash in March 2020. It happened
in 2006 …before the Great Recession. In fact, it’s happened before the last 8 recessions.
And… parts of the yield curve are inverting today.
What exactly all that means and what we can learn from history to best help you prepare
for the future… coming up! –
Welcome back you savvy 17,000 subscribers. I appreciate you. And I laud your curiosity
as we try to figure this all out and find the best ways to invest. And even if you don’t
invest directly into bonds, their insights can be extremely valuable for stock and real
estate investors alike.
But before you can understand what the bond market yield curve is telling you, you have
to have (at least) a basic understanding of how bonds work.
Here’s a simple example: pretend you loan me $1,000 (thank you) on the condition that
I pay you $50 every year for 5 years and then pay you back that full $1,000 at the end of
those 5 years. If I were a business or the government (in that example), that loan is
a bond - in this example, it’s a bond with a 5% interest rate - $50 is 5% of the $1,000
principal.
But now, after you’ve purchased this bond from me, if you decide you want to sell our
contract - so that somebody else owns the right to my regular payments of interest and
the ultimate $1,000 I’ll pay back at the end of our term - I don’t care - by all
means, sell the bond in the “secondary” market for whatever you want! (It’s all
the same to me - the corporation / the government.)
Now, if you go to sell it in a year and now all the issuers of bonds are selling them
with higher interest rates, say 10%, instead of the 5% I’m paying, is anybody going to
want your bond?
Well, sure… but they won’t want it at the price (or value) you paid for it. They’ll
want it to be discounted, so that their YIELD is ultimately closer to what they can get
somewhere else. If they can get 10% in the open market, and we all have the same credit-worthiness
(or ability to pay), well, investors are going to want that same yield from any bond contract
they might buy from you. So if you discount all those future payments (the $50 per year
and the $1,000 lump sum at the end of the term (now, 4 years away)...) - if you discount
all those payments by the prevailing rate (now 10%) - a bond investor would be willing
to pay about $842 for it. Which means, over that single year, you’ve lost around 11%
on that investment. (Even despite the $50 I paid you for that first year. Now you know
how those bond investors we were talking about a couple of days ago feel so far this year!)
…
But the inverse is also true (of course). If interest rates start to drop and you’ve
locked in this higher rate, your investment is naturally going to be worth more. Say when
you go to sell your bond in a year, the prevailing rate is only 2%, instead of 5 or 10 percent.
Well now, when you discount your bond’s future cash flow back to today at a yield
of 2%, your bond is worth $1,114 - which would represent an ROI of more than 16%. That’s
great for a bond investor.
Now you can understand why bond investors have done so well over the last several decades
as interest rates have fallen from almost 20% in 1980 to (almost) 0%.
With that example, hopefully you have a better idea of the difference between the bond's
interest rate and its yield and the consideration that bond investors are making as they purchase
bonds with various maturities - that is, the length of time between now and when they would
get their principal back - effectively, it’s how long they’re locking themselves into
that rate.
So normally, you would expect a later maturity to be able to demand a higher yield. You’re
locking yourself into that rate for a longer period of time - whether the prevailing rates
fall or … go sky high.
So here’s what a normal yield curve should look like. I pulled this data from the US
Treasury’s database.
The shorter maturity treasury bonds have yields very close to whatever the fed funds rate
is. But of course, the further out you get, under normal conditions, investors require
higher and higher yields, with it usually leveling off at the higher maturities.
But put your bond investor thinking caps back on for a bit….
If you’re the portfolio manager of this big ol’ pension fund or life insurance company
- you’re trying to be savvy and safe with the money you’re in charge of investing.
Now, let’s say, all your high-tech, expensive analysis tools and maybe even staff research
analysts or consultants are telling you that the economy is crazy healthy - things are
taking off; growth is inevitable, and… inflation probably is too, but since the economy is
healthy, the Fed will be able to raise rates significantly over the coming decades to keep
up with that inflation… Anyway, there’s your summary analysis. So, as this big shot
investment decision maker for this massive conservative portfolio… Do you lock yourself
into a 30-year bond yielding a measly (let’s say) 2%? (1) inflation (2) healthy economy
(3) rising rates - No! If that’s what were to be offered, you’ll just stick to the
shorter maturities so that as they mature, you’ll be able to invest at higher and higher
rates. Right? That would be the astute thing to do.
But wait, if all of the behemoth portfolio managers (that’s a reference to the size
of the portfolio, of course, not …you) … if they’re all seeing these same things - or
consulting the same …consultants, well… they don’t want the 30-year bonds for a
measly 2% either. And well, if there are no buyers and the treasury department is trying
to sell them… well, basic supply and demand… they gotta offer more - they gotta up the
interest rate!
So, that kind of optimistic outlook can lead to a steeper than normal yield curve. It shoots
up quicker than normal and doesn’t necessarily ever level out.
Here’s what it looked like toward the end of the Great Recession, for example, as the
economy was clearly starting to roar up again.
So, as a mere observer of the yield curve - and not actually a big-shot portfolio manager
- I mean… if you are… cool. But most of us, at least, are not. We’re just reading
the tea leaves that are the yield curve inputs. So, as an observer of the yield curve, when
you see this steeper pattern, now you know what some of the largest players in the investing
world - remember, the bond market is way bigger than the stock market - what the largest players
in the investing world are expecting - what they’re seeing with their vast and cutting-edge
resources.
Pretty cool, right?
A flattening yield curve can imply uncertainty or uneasiness about the future. Companies
are willing to lock in long-term rates even if they’re similar to the shorter-term maturities.
As you can understand now, that’s not a great sign.
And when the yield curve inverts - meaning these massive and savvy institutions are even
willing to lock in long-term rates that are lower than what they could get with shorter-term
maturities… What do you think that means about their educated expectations for the
future?
Not Good!
Yield curve inversion does not happen very often and is strongly suggestive of a severe
economic downturn.
David Kelly from JP Morgan quoted for the Financial Times:
“An inverted yield curve doesn’t do much to the economy, but it’s a very bad sign.
The only reason you’d buy a long-term bond at a lower yield than a short-term one was
if you thought yields were going to fall . That usually happens when most people think the
Fed has gone or will go too far.”
And on March 28, the spread between the 5-year notes and the 30-year bonds inverted for the
first time since 2006.
The bond market thinks “the Fed has gone too far”?! After a single hike… yikes…
more on what all that could mean in a second.
Here’s where we are today…
Historically, the most indicative inversion has been the spread between the 10s and the
2s - the 10 year and 2 year maturities. And you can see here from the Treasury database,
that the distance between the two is getting awfully tight.
In fact, Seeking Alpha reported: “The yield on the 2-year Treasury briefly
exceeded the 10-year on Tuesday for the first time since 2019, in a warning sign that coming
Fed rate hikes may trigger a recession. The inversion … only lasted several minutes
before things returned to a 5 basis point spread.”
It was this 10-2 spread that inverted only briefly in 2019… which was followed by the
Covid Crash in March 2020. It happened for much of 2006 and into 2007. It was even more
inverted in 1998 and ‘99. In fact, as I pointed out at the top of the video, such
an inversion has occurred before all of the last 8 recessions.
– Now, it’s very tempting to argue that “this
time it’s different.” Whew, isn’t that a common refrain in the financial industry.
Isn’t it? Well, it absolutely is different. But it’s also ALWAYS different. That’s
a big problem I have with the stock and bond only philosophy - yes, the inputs, the variables
are always different - so nothing is perfectly predictive. (It seems that the industry likes
to use this logic selectively…) The bottom line to that logic is: you always have to
proceed with caution… with any of this stuff!
So sure, be cautious, be skeptical if you want, but don’t be stupid. Don’t entirely
write it off.
Erin Browne, a fund manager at PIMCO, said "There's reason to believe that this time
around, yield curve inversion may not be as good of an indicator as it has been in the
past, particularly given the enormous amount of quantitative easing undertaken by global
central banks."
Sure. Be skeptical. Be cautious. I agree, the Fed is a big differentiating variable
this time around. In fact, look at all this data (as compiled by the firm Real Investment
Advice) that economists could point to to suggest a healthy economy.
So, maybe it is wrong this time. Oh wait… no. Sorry that was the data from 1999… a
bit after the 10-2 yield curve inverted.
Right, sorry. My mistake! The runup to 2008 was similar - most economic variables looked
strong - there seemed to be no clear indications of a coming recession. And here’s all that
data today. Yeah, for the most part, it looks good… I give you the information, you draw
your own conclusions here.
I do think the Fed’s hyperactive involvement is different. But I think - because of past
policy decisions they made - they’ve really dug their own grave here. They’re stuck
between a rock and a hard place - there is no easy way out. You see, they have contradictory
objectives here. (1) They need to keep inflation under control. (2) But they also know that
they’re going to get blamed if the economy starts to go into a recession - so you bet
they’re trying real hard to not trigger that.
Here’s Congress trying to point this out as they interview the Fed Chair…
“Is the leadership at the Fed - under you …and the Fed - prepared to do what it takes
to get inflation under control and protect price stability?”
“Well, let me say: I knew Paul Volcker. I’m pretty sure I saw him testify in this
room many years ago. I think he was one of the great public servants of the era - the
greatest economic servant of the era - and I hope history will record that the answer
to your question is yes.”
“So, you’re prepared to do what it takes without any reservation to protect price stability?”
“Yes”
“Well… that would be a departure from what you’ve done! [mic drop] Thank you very
much.”
… The political talking point right now is that the economy is booming. But the Fed’s
actions belie their posturing on this issue. They acknowledge the Paul Volcker “whatever
it takes to beat inflation” attitude but their policy decisions are far …FAR from
that. I talk in more detail about that in this video that I’ll put in the card and
link out to in the description. But yeah, for quick context: he attacked inflation by
allowing the Fed Funds rate to soar to almost 20%.
Yet now, as we experience runaway inflation similar to, if not greater than, (...) what
we experienced back in the ‘70s, and for months we just talk about (and then, sure,
finally execute on) raising interest rates by 25 basis points or 0.25% all while we continued
to buy more treasuries pumping even more money into circulation… yeeeeah… he’s really
channeling his inner-Volcker there, eh?
What’s more telling about (at least) what the market expects the Fed to do, is… the
yield curve. Remember what it looks like if the economy is healthy and investors fear
inflation? A steeper than normal curve. It makes sense: everyone is worried about inflation
going up, over the long run the Fed will obviously have to raise rates to get ahead of it, the
economy is actually healthy enough to handle that said raising of rates, so one would actually
expect the Fed to follow through without backlash, which would mean when they do raise the rates
conservative investors WOULD have access to even higher interest rates to invest their
money, so… in that scenario, if you want me to lock my money up into some interest
rate today, it better be worth my while. Right? You’re gonna have to pay me much more than
I could get in the short term market to buy your long term stuff when I think there are
going to be higher yielding opportunities later.
But if that’s not what we’re seeing - which we’re not - remember, the 30s are below
the 3s… and were for a moment below the 5s… then what does that mean. It means,
the market doesn’t actually believe the economy is that healthy and that it expects
the Fed to bend to the political pressure that WILL come from the inevitable recessionary
scares we’re about to experience.
In my humble opinion… if the Fed continues raising rates, there will be a recession.
I actually think a real “resetting” recession is long overdue, and it’s just been made
worse by all the can kicking over the last couple of decades. Maybe that’s an unpopular
opinion - it certainly would not go over well politically as it WOULD be painful (even if
necessary…)
But - again, in my opinion here - the real question is just WHEN the Fed will change
its policy again. When they will back off these “aggressive” tiny-tini rate hikes
because the recessionary political pressure has grown too great.
They’ll have to make up some excuse to try to save face so they can back off of their
“aggressive anti-inflationary” policy…
Now, don’t get me wrong: I don’t think they’ll prevent a recession by doing this
(at some point it will become inevitable), but they might be able to kick the can just
a little bit further down the road. Maybe even long enough to be able to blame another
administration.
Anyway, I think that’s what’s going on here - at least, that’s my interpretation
of the tea leaves that is the yield curve. –
Now, a couple of important things to note. Even after the 10-2 spread inverted before
the last 8 recessions, the market tended to surge upward before its ultimate and significant
downturn. In fact, on average, it took 17 months before a recession finally came to
bear.
Also, over that same time period - since the ‘70s - some argue this indicator has given
off one or two false alarms. (But that’s it…)
In the end, I think it is important to note as Ben Emons, a global macro strategist with
Medley Global Advisors pointed out, "Historically, a recession has not happened without an inversion,
so likely, it will be a predictor of a future recession. Timing, however, is unknown. It
could take up to two years." –
Amid all these concerns, my goal is just to be able to help you invest smarter. For you.
Finding the best strategy that will work for you is a very individual thing.
If you want to know some of the best places to invest during inflation, I put together
this video just for you. And if you’re trying to improve your individual stock selecting
skills, you should check out this playlist. All of those will help you be better prepared
for what’s ahead…
Let me know in the comments how I can help. I love getting to know you all better. I wish
you all the best. Take care.