The US stock market suffered its largest decline of the year earlier this month, dropping about 3 percent in a single day. While many opinions were proffered about the reason behind the decline, one common explanation was the inversion of the yield curve. Unless you’re a macroeconomic wonk, you’ve probably never heard of a yield curve much less understand what its inversion could portend for your financial future. Does it mean the stock market is headed for bear market territory?
The short definition of a yield curve is that it reflects the current yield (interest by another name) paid by bonds over different maturities, ranging from short to long term. A bond is like a CD in that it is a promise to pay your principal back when it matures and interest along the way. Treasury bonds are among the highest quality and most traded.
When we talk about “the” yield curve, we mean the yield for US Treasury bonds for maturities from one month out to thirty years. You can find the current curve at treasury.gov. In normal markets investors demand higher yields for longer-term bonds. After all, there is more risk that interest rates will turn against you with a bond that matures in twenty years versus six months. For that greater risk, bondholders should normally expect higher interest, just like you want a better rate for a five year CD than a twelve month one.
Last week we briefly had an inverted yield curve in which the yield of two year Treasury bonds exceeded the ten year Treasury yield. It’s a sign that the bond market is pricing in a slower economy in which the Federal Reserve will be motivated to lower short-term interest rates to prevent an economic swoon.
Are we headed for recession? Perhaps. It turns out that inverted yield curves are rare with only nine occurring in the last fifty years. We have seen recessions in seven of those cases within two years of the initial inversion. Therein lies the rub. The economy may usually fall into recession (though not always) at some point after a yield curve inversion, but the stock market may perform well in the interim.
The S&P 500 index that tracks US large company stock prices on average increased 13.5 percent in the year after the initial yield curve inversion, according to Dow Jones Market Data. The data for two and three years out from inversion is less rosy. What’s clear is that trying to time your portfolio moves using the yield curve as your guide is tricky.
Rather than making a rash portfolio decision,use low yields for your personal advantage. The yield curve may be inverted but it’s very low by historic standards. Currently thirty and fifteen year mortgage rates are very attractive, averaging 3.7 and 3.1 percent respectively. It may make sense to refinance to a lower rate, particularly if it can be done for little or no cost.
If you hold bonds in your portfolio,you should favor short and to intermediate term bonds as you now get less yield and more volatility with bonds longer than ten years. Finally, if you’re feeling nervous about your investments, this is the time to imagine how they would perform in a bear market, defined as a market decline of at least 20 percent. You need to be disciplined in the midst of such a decline and re-balance back to stocks. If you won’t be able to do that, it’s best to revisit your stock and bond mix now while US stock prices are within 5 percent of all-time highs.