Interest rates behave in normal patterns. But sometimes they misbehave. One of these events is known as an inverted yield curve. It may not be anything you’ve ever heard of in the past, but if you’re an investor, it can have a significant impact on your portfolio.
What is an Inverted Yield Curve?
In the normal course of events, interest rates on bonds will rise by term length. Shorter-term bonds will have lower yields than medium-term securities, which will in turn have lower rates than long-term bonds.
This is the current situation with yields on U.S. Treasury securities. For example, as of July 27, 2018, yields on U.S. Treasury securities looked like this:
- 1 year, 2.43%
- 2 year, 2.67%
- 5 year, 2.84%
- 10 year, 2.96%
- 30 year, 3.09%
Notice the steady succession of higher yields with increased terms. This is considered to be a normal yield curve.
An inverted yield curve might look something like this:
- 1 year, 3.50%
- 2 year, 3.35%
- 5 year, 3.25%
- 10 year, 3.05%
- 30 year, 2.95%
Notice under this pattern, the opposite occurs. Interest rate yield falls the longer the term of the security.
This is an unusual situation because the length of a bond term is one of the primary risk factors to the security. Since the near-term is more predictable than the long-term, investors will normally require a higher interest rate yield on longer-term securities.
What Causes an Inverted Yield Curve?
An inverted yield curve doesn’t usually happen quickly. It may be preceded by a time when interest rates even out, referred to as a flat yield curve. In this environment, the difference between short-term and long-term interest rates narrows. This can precede an inverted yield curve.
The cause of an inverted yield curve is usually the expectation of an economic decline or recession. It’s an indication market sentiment considers the long-term outlook to be bad, and that long-term yields will decline in response.
Still another cause can be a flight to higher-quality investments. For example, if investors, especially foreign investors, sense instability, they may increase purchases of interest-bearing securities. This purchase activity is usually concentrated in U.S. government securities, which are considered the safest of all investments.
As investors pour into long-term debt, yields drop in response to the additional capital flowing into the market. If the interest is particularly concentrated in longer-term debt, rather than the shorter-term variety, it might result in an inverted yield curve.
Has an Inverted Yield Curve Ever Happened Before?
An inverted yield curve is more than just an interesting phenomenon. Every recession since 1956 has been preceded by one. This may be in part because recessions are often caused by an increase in short-term interest rates. This happens as the Federal Reserve increases the Fed funds rate, which is a short-term interest rate. The Fed has little impact on long-term rates, which holds the potential for short-term rates to rise above long-term rates.
An inverted yield curve has proceeded the last seven recessions, including most recently the 2000 Dot.com Bust, and the 2007-2009 Financial Meltdown.
The connection between inverted yield curves and recessions has been too predictable to be coincidence. It may be that the expanded use of credit since World War II has placed increased emphasis on interest rates as a primary driver in the economy.
Are We Close to an Inverted Yield Curve Now?
No one has a crystal ball, but since recessions happen every few years–and the last one ended nine years ago–it’s certain we’ll have another one. Probably sooner than later.
One indication of the formation of an inverted yield curve is that the Federal Reserve has been raising short-term interest rates for the past couple of years.
It’s also worth noting that the current yield spread between short-term and long-term interest rates is very low by historical standards. In the U.S. Treasury yields shown above, a one-year Treasury bill has a yield of 2.43%, while the 30-year Treasury bond is yielding just 3.09%. That’s a spread of just 0.66%, which is well below 1%.
There’s no way to know if and when an inverted yield curve will hit. But with interest spreads as tight as they are already, it wouldn’t take much for it to happen.
How Might an Inverted Yield Curve Affect Your Investments?
Since interest rates affect most economic activity in the economy, they tend to have an important impact on investing.
Interest-bearing investments compete against stocks for investors’ capital. If short-term rates rise, it could result in a decline in stock prices. This happens because high-yielding, totally safe short-term investments draw capital away from stocks. Stocks after all, involve fluctuating valuations. In times of uncertainty, higher-yielding securities are preferred. This will naturally have a negative effect on the value of your investment portfolio.
Borrowing will also be affected. Since consumer financing is often based on short-term rates, an inverted yield curve could result in higher rates being charged on auto loans and credit cards. This will have a negative impact on the economy, which will affect not only investment portfolios, but also employment.
Still another essential investment impact is with housing. Though 30-year fixed rate mortgages may be relatively unaffected by an inverted yield curve, variable mortgages, like adjustable-rate mortgages, may see an increase in rate and payment. This can cause instability among existing homeowners, who will see their house payments suddenly increase. That can hurt property values, particularly if it results in an increase in foreclosures and short sales.
How to Invest into an Inverted Yield Curve
One outcome in an inverted yield curve that’s absolutely certain is that investing becomes a higher risk venture. For that reason, you’ll want to become at least a little bit more conservative.
One important way to do that is to be very careful with your choice of investment platforms. You may want to move toward a professionally managed service. One worth looking at closely is Personal Capital. They provide the type of professional investment management you’ll get from traditional investment managers, but at just a fraction of the management fee.
Another option is to go with a good robo-advisor. Two prominent examples are Betterment and Wealthfront. They put investing on automatic pilot. You can choose a more conservative investment mix, to weather any storm that might be caused by an inverted yield curve.
And if you want flexibility, you could use a platform like Charles Schwab or Ally Invest. Both provide all the tools you need to be a successful self-directed investor, but also a managed investment option. Charles Schwab Intelligent Portfolios and Ally Invest’s Managed Portfolios give you the option to have at least some of your portfolio professionally managed.
The basic idea is to lower your exposure to the ravages of an inverted yield curve. If you’re not sure how to do this, professional investment management is the best way to move forward.Topics: Investing