Reindeer and inverted yield curves: what can we learn after 5000 years of economic trade?
We’re almost halfway through the year, and the yield curve has been on the media’s mind. Coming off of 0% interest rates following the US housing recession in 2008, the U.S. Federal Reserve has been in an interest rate hiking cycle since late 2015. But how far is too far? Have we reached the tipping point? Today, short term interest rates are higher than 10 year interest rates, which means that the yield curve has inverted. You may have read that a yield curve inversion has always been a predictor that a recession is coming. There is certainly some truth in that statement, but I want to spend some time explaining why we care, as well as why we look at more than one aspect of economic health when we think about and prepare for an impending recession.
What is an inverted yield curve, anyway?
Put simply, an interest rate is the cost to borrow money. Interest rates have been around in some form for thousands of years. Even though it wasn’t always quoted as a rate, there was some inherent value to lending. Sidney Homer & Richard Sylla’s book, The History of Interest Rates, gives a fascinating look into how interest rates have changed over time. Dating back to 3000 BC, grains, animals and other commodities were lent for a specific rate of interest, estimated at 20-25%. There have been some exceptions to these rates, for instance in pre-modern Northern Siberia, reindeer were lent between families with the expectation that the reindeer borrower would return the original reindeer, plus another — i.e. an interest rate of 100%!
Fortunately for us today, we have currencies and a transparent marketplace for interest rates around the globe. So let’s transport back to modern markets...
Interest rates sit at the core of how money in the world is managed and invested, and the yield curve is a big part of that. Individuals, companies and countries will borrow money to invest for their future, and that borrowed money is assigned a specific interest rate. The interest rate is an indication of a given level of risk, both for the money borrowed and the opportunities elsewhere. As a lender (or a buyer of debt), you are likely to lend your money to someone for longer if they pay you a higher level of interest. That higher level of interest is your compensation for taking the longer term risk.
A yield curve plots the interest rate of a specific bond with varying terms. The most commonly cited yield curve - referenced in this article as ‘the yield curve’ - is for US treasury bonds, which shows the interest rate on a 3 month, 2 year, 5 year, 10 year, 20 year and 30 year treasury bond.
In the US, the X axis starts at 3 months and ends at 30 years, which is the longest term bond possible in the US. In a country like Argentina where they offer 100 year bonds, the X axis would end at 100. Below is a chart that shows the US yield curve on January 8, 2019 (light red) and again on June 20, 2019 (dark red). The yield curve changes on a daily basis just like the stock market!
www.stockcharts.com
In a normal market, the yield curve is upward sloping because an investor would expect to be compensated more when lending money for a longer period. This means that with all else being equal (location, quality, marketability), rates for 2 year bonds should be higher than 3 month bonds, and similarly rates for 30 year bonds should be higher than 10 year bonds. This is what we see in the light red line above. The difference between the two quoted rates (the dots on the yield curve where X=time and Y=percentage) is called the ‘spread’. As an investor, you should analyze if the spread is worth the risk of time.
Yield curve inversions are when short term rates are actually higher than long term rates. And it makes sense why this is alarming — why would I lend money for a longer period of time for less? If I can lend for two years at 2.5% or ten years at 2%, wouldn’t I rather just lend for two years, get the 2.5% and then lend for another 2 years at 2.5% ?
Why did the yield curve invert this year?
The Federal Reserve has been raising its target rate since late 2015, and as we came into this year, the predictions were that the Fed would continue along this path. But just because the Fed is raising the target for short term rates doesn’t mean that long term rates will follow. When long term rates don’t follow short term rates - the yield curve can invert. Why wouldn’t long term rates rise at the same pace as short term rates? There are tons of economic theories on what drives longer term interest rates, but the main drivers include:
The supply and demand of currency.
The supply and demand of bonds.
One of the causes of lower long term interest rates today is the demand coming from countries around the world who are buying US long term treasury bonds. In today’s global bond market, $20 trillion of the $55 trillion sovereign bonds outstanding (bonds issued by governments) have a rate less than zero. Think about how crazy that is -- would you pay your bank to keep your money safe for you? No!
Just like you, big institutions and governments would rather make some money on their cash, which is why they turn to the United States longer term Treasuries -- one of the few ‘safe’ sovereign bonds yielding more than zero.
Does an inverted yield curve mean we’re going into recession?
Our short answer: not necessarily.
The yield curve is an important factor to watch, but just one of ten leading indicators. The yield curve inversion should not be looked at in isolation as a predictor of what’s to come. The Conference Board produces the Leading Economic Indicators on a monthly basis. We use economic indicators to measure the health of the US economy. When the average of these indicators is rising, it is expected that the economy in the future is in a good position. When it’s falling, it is expected that there may be some trouble ahead.
The Conference Board also compiles the Coincident Economic Indicators, which are more of the ‘real time’ assessment of what is going on in the US economy. The chart below shows both the Leading Economic Indicators and Coincident Economic Indicators. The light blue shaded areas are recessions according to the National Bureau of Economic Research.
An inverted yield curve isn’t enough of a signal that the economy is in trouble. Instead, it’s a call to investigate it along with the other nine indicators.
How do we contextualize indicators? Here’s an example with housing.
Housing itself is only a small component of our leading indicators, but it’s so important because of its impact across so many of the other leading indicators. Individuals borrow money, which helps the banks (stock prices, unemployment). They buy homes, which helps home prices (consumer expectations). They buy appliances and furniture, which helps retail (consumer goods). They have construction done, which helps manufacturing (manufacturing hours worked).
What’s going on in housing?
Cons: We reached peak housing over a year ago, and a decline in housing starts has been a leading indicator for the recession.
Pros: With interest rates falling into this year, new homes sales made a new cycle high in March and rose 7% year over year in April. Falling rates makes borrowing to buy a home more affordable. While housing has been a strong leading indicator, it has also had ‘false positives’ of predicting a recession. During each of the five times there was a ‘false positive’ -- i.e. no recession, Bespoke writes: the Federal Reserve was easing monetary policy during or shortly thereafter the 12-month low readings in Housing Starts. As the Fed talks about becoming more flexible in terms of raising or lowering rates, monetary easing is in the cards.
Don’t let the news cloud your long term plan
Although it’s widely broadcasted that a yield curve inversion is the indicator that a recession is coming, research from Dr. Ed Yardeni shows that viewing this statistic in isolation can lead to poor results. Yardeni’s research study The Yield Curve: What Is It Really Predicting? states: “Prior to the last seven recessions, the yield curve inverted with a lead time of 55 weeks on average, in a range of 40-77 weeks. It gave a few false, though short-lived, signals along the way, during the 1980s and 1990s. For example… the yield curve turned negative a couple of times in 1995 and again in 1998. The recession started a few years later, in March 2001” and lasted 8 months. Since World War II, there have been 10 recessions in the United States ranging in length from 6 months to 16 months, with an average of about 10 1/2 months.
The market has come a long way since the days of trading reindeer and grain, but just because it’s easy to trade, doesn’t mean we should. Reacting to news and trying to time the market could lead to months or years lost of growth through compounding. Instead, develop a plan that begins with what you are investing for and how much time you have to invest. Your plan should have an investment policy that objectively outlines how much you should be invested in stocks, bonds and cash. The longer you have, the more likely it is that you will achieve the long term averages. Remember: when it comes to investing, time is on your side and recessions are a normal and necessary part of a functioning economy.
Stephanie Bucko is a fee-only financial planner based in Los Angeles, California and is the Chief Investment Officer of Mana Financial Life Design. Mana Financial Life Design provides comprehensive financial planning and investment management services to help clients organize, grow and protect their wealth throughout life’s journey. Mana specializes in advising professionals in the tech industry, as well as women who work in institutional investing, through financial planning and investment management. As a fee-only fiduciary and independent financial advisor, Stephanie never receives commission of any kind. She is legally bound by her certification to provide unbiased and trustworthy financial advice.