Short-term interest rates have been inching up faster than long-term rates, a condition called a “flattening yield curve” that for decades has predicted recessions and put investors into a quandary.
What should investors do? The options range from nothing to changing holdings to employing strategies to either grow or protect the portfolio, to putting money on the sidelines for safe keeping.
“The yield curve is one of the single most effective recession indicators available to us as investors, it is almost never wrong,” says Patrick R. McDowell, investment analyst at Arbor Wealth Management in Miramar Beach, Florida. “We believe the yield curve will invert in the next 12 months,” he says.
“Every U.S. recession in the past 60 years was preceded by …. an inverted yield curve,” the Federal Reserve Bank of San Francisco says in a March 2018 study, adding that inverted curves have been followed by recessions in all but one instance over that period.
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The yield curve is a graph with bond maturities on the horizontal axis and yields on the vertical one. Most of the time short-term bonds have lower yields than long-term ones, because investors demand more for tying their money up longer and exposing their holdings to the unknown. The curve starts in the lower left and rises steadily to the right as maturities and yields go up.
But every so often the gap between short- and long-term yields shrinks to almost nothing, and sometimes the curve “inverts” so that short-term yields are higher. The curve flattens rather than rising, or heads down instead of up.
This tends to happen when the Federal Reserve pushes up the short-term interest rates it can control while investors push down long-term yields because they expect the Fed to reduce short-term yields in the future to stimulate the economy in a downturn or recession. (Lower interest rates make it cheaper to borrow, increasing spending to perk up the economy.)
Long-term yields are governed by supply and demand in the bond market and represent the combined wisdom of vast numbers of bond investors.
Currently, the 10-year Treasury note yields 2.9 percent, not much more than the two-year’s 2.66 percent. Two years ago the rates were 1.55 percent and 0.74 percent. Shrinking the gap from 0.81 to 0.24 may not seem earth shaking but is a red flag on the economy.
Though a recession is likely if the curve inverts, this is not necessarily a bad time for investors, says Craig Thompson, president of Asset Solutions in Lafayette, Louisiana.
“The yield curve has not inverted yet and even when it does the lead time for a stock market peak can be considerable,” Thompson says. “Yet, it is something to monitor given we are at the end of the current period of economic expansion. So, yes, we are in a bull market and should be invested in stocks. However, the bull market will not last forever and we are probably at the tail end.”
Investors can react in various ways depending on how much risk they like to take.
For income-oriented bond investors the safe course is to load up on shorter-term bonds in the belief long-term bonds no longer offer the extra income needed to justify the risk of bad things happening before the bond matures. Compared to a two-year note, a 10-year note entails much more risk that the economy could collapse, the bond issuer could default, or that rising interest rates could make existing bonds lose value as investors prefer newer ones that pay more.
The damage from rising rates is much more severe for long-term bonds because the consequences last so much longer.
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Bond risk can be measured with duration, a figure that indicates how much value a bond or bond fund could lose for every one-percentage point rise in prevailing interest rates. A bond with a 10-year duration could lose 10 percent, while one with a two-year duration only 2 percent.
“Investors should continue to keep duration low and [hold] high-quality investment-grade bonds … to help hedge against rising rates in the future,” says Jordan Niefeld, planner with Raymond James & Associates in Aventura, Florida. He also recommends keeping cash on the sidelines to weather market jolts.
“An individual investor should look at the bonds they own and make sure they mature within three to five years,” says Alan J. Conner, president of NovaPoint Capital in Atlanta. “These bonds will provide the best combination of relatively high interest rates and lower interest-rate risk, allowing investors to wait out this transition period, and perhaps invest at higher rates as the yield curve normalizes.”
On the other hand, investors who move quickly enough can bet that long-term yields will fall further as the curve flattens even more and then inverts. Falling interest rates push existing bond prices up because investors would rather have older bonds that pay more than newer ones.
“People think shortening their duration exposure is the appropriate response to a flattening yield curve when in fact the opposite is true,” McDowell says. “If you could execute it seamlessly, you’d want to be shorting short-term bonds and buying long-term bonds to bet on that type of yield curve inversion, even though on an absolute [income-paying] basis short-term bonds are much more attractive.”
The ultimate play, he says, is to buy long-duration zero-coupon bonds, which deliver their accumulated interest earnings only when the bond matures. These bonds are extremely sensitive to interest rate changes and can be very profitable if rates fall — but are big losers if rates go up.
Betting on price changes from changing yields is speculative, perhaps not the best option, many experts say, for investors using bonds for income or to reduce the ups and downs of a portfolio that also has stocks.
As for equities, a flattening yield curve may forecast a slower economy, which can hurt corporate earnings and stock prices, but that doesn’t necessarily mean stockholders should run for the exits, says Brenda Wenning, principal of Wenning Investments in Newton, Mass
“The stock market has produced gains in four of the last five periods when the yield curve inverted,” she says. “Going back to 1978, the S&P 500 has risen about 16 percent in the 18 months following an inversion, according to a new analysis by Credit Suisse. Over 24 months following an inversion, stocks rose an average of 14 percent and over 30 months, they rose an average of 9.5 percent.”
The likely reason: stocks are a bet on the future and investors bid up prices when they anticipate higher corporate profits after a recession ends.
The anxious stock investor’s most obvious choice is to play it safe in uncertain times by trimming stock holdings and putting the proceeds on the sidelines as cash.
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But advisors generally warn against betting on short-term market swings and instead hanging on to stocks through a recession to enjoy the rebound that follows.
Wenning says investors should not be alarmed.
“While other factors point to a potential slowdown in the fourth quarter, it appears that a recession remains far away, even if the yield curve inverts,” she says.
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Why Investors Watch the Yield Curve originally appeared on usnews.com
