You may recall hearing that the Treasury yield curve inverted recently. Many investors thought it was a pretty big deal. Here’s why.
Corporation or governments issue bonds to raise money.
Think of a bond as an IOU. When an investor buys a bond, money is essentially lent to the bond issuer, who promises to pay back the original loan amount – plus interest – over a set period.
What Are Yield Curve Inversions?
There are several ways to categorize bonds. For our purposes, let’s categorize them by maturity date – in other words, how long before an investor receives their initial investment back from the bond issuer after purchasing the bond.
In this case, the bond issuer is the U.S. government, and the bonds in question are U.S. Treasury bonds.
The Treasury yield curve shows the interest rates paid by Treasury bonds of various maturity dates. In general, a bond that has a shorter maturity date (let’s say one year) should pay a lower interest rate than a bond that has a longer maturity date (10 years or longer).
Plotting these maturity dates and interest rates on a graph will produce a line that slopes upward from left to right. This slope is considered normal and usually indicates healthy economic conditions.
On rare occasions, the interest rates on shorter-maturity bonds are higher than on longer-maturity bonds. When this happens, the left-to-right upward-sloping yield curve inverts; that is, it moves to the right in a downward slope.
Since February 2018, the Treasury yield curve’s slope has been flattening, and in early December, it briefly inverted.
The inversion was newsworthy because one has preceded every recession since 1962 – by 10 to 34 months, to be exact. The relationship between the 2-year Treasury bond and the 10-year Treasury bond is of particular interest.
Why Are Yield Curve Inversions Bad For the Economy?
Inversions deter banks, who generally profit from borrowing at short-term rates and issuing loans at long-term rates, from lending money to consumers and businesses.
A deceleration in bank lending – including mortgages and personal and business loans – can cause ripples across the economy.
When consumers face difficulty in borrowing money, the housing market can stagnate. Consumer spending—which drives over two-thirds of the American economy – also wanes.
When companies have a hard time borrowing money, they often stop hiring new workers and cancel projects. Layoffs and even business closures tend to follow.
As unemployment rises, gross domestic product (GDP, or the monetary value of all finished goods and services produced by a country) sinks, triggering a recession if the contraction lasts for at least two consecutive quarters.
So how does this affect someone who is nearing (or in) retirement? Recessions tend to be tied to bear markets – when the stock market declines 20% or more for 60 days or longer. Bear markets typically last between 10 and 15 months.
For younger investors who are years away from retirement, bear markets have less of an impact. But investors who are retired, or who soon will retire, have less time overall to make up for significant losses in their portfolio.
Knowing that recessions are an inevitable part of the economic cycle doesn’t necessarily make them any easier to face. A smart asset allocation strategy that offers risk mitigation can help older investors sleep better at night through all kinds of market conditions.
Market volatility has elevated since February 2018. As year-end has drawn closer, we’ve seen big fluctuations with more frequency – and there’s no indication that this wild ride will end anytime soon. If the possibility of a recession has you feeling uneasy about your portfolio, contact a member of our advisor network for a no-cost, no-obligation review.