For the first time since 2008/2009, we have a new term creeping into the daily news: Inverted Yield Curve. Missing from all the dire predictions of what an inverted yield curve portends seems to be an explanation of what an inverted yield curve actually is. In this article, we’ll do our best to answer the following questions:
- What is an inverted yield curve?
- What does it tend to imply?
- Are there any specific strategies to employ if the yield curve stays inverted?
Definition of an Inverted Yield Curve
In a normal interest rate environment, the yield of a 10-year bond is going to be higher than the yield of a two-year bond. In other words, the buyer of a longer-term bond receives higher interest payments than the buyer of a shorter-term bond. This makes sense because investors generally require higher returns the longer they have until maturity. In this case, a 10-year bond represents 10 years worth of risk, where a two-year bond only represents two years worth of risk.
A good example of a normal yield curve would be a 2% yield on a 10-year bond and a 1.50% yield on a two-year bond. The yield of these two different bonds can be plotted in a graph and show a curve, like in the image below:
An Inverted Yield Curve occurs when the yield of a 10-year bond is lower than the yield of a two-year bond. For example, perhaps the yield on a 10-year bond is 1.55% and the yield on a two-year bond is 1.60%. When this happens the curve on the graph becomes inverted to display shorter-term yields being higher than longer-term yields, like this:
What does an inverted yield curve imply?
Over the last 30 years or so, the yield curve has inverted (defined as inverted for 1 month or longer) a total of eight times. Of the eight inversions, four preceded recessions. One may ask, “does an inverted curve cause a recession?” and the answer is no. An inverted curve implies that the Fed will soon be lowering interest rates because the economy is slowing. In anticipation of lower rates, investors are more interested in buying longer maturities than they are shorter maturities.
Strategy for an inverted yield curve environment
If the curve does indeed invert (which it did for one day recently) for more than 1 month, it implies that the Fed is worried about a recession. When the Fed worries about a recession, it usually lowers interest rates to combat that recession. In a falling interest rate environment, we like to add duration to our bond portfolios to capture some of that expected bond price appreciation.
However, in a very low interest rate environment, we are cautious about going out too far “on the curve.” This just means we want to be careful about owning very long-dated maturities. Why? Because of the inherent price risk in a rising rate environment. (For further information on price risk versus bond maturity, read this article).
From a strategy perspective, we will be moving out of shorter-term maturities to intermediate-term. For instance, we will look to sell 1, 2, and 3-year maturity bonds and buy in the 5, 6 and 7-year area of the curve. And, depending on a person’s tax situation, we are taking profits on the longer bonds (10-20 years) to lock in gains.
Questions? Comments? Reach out to us. We have extensive knowledge and experience with bonds and would welcome your feedback or questions.
