Economic Notes: Yield Curve? Recession? What to Know.
There has been a lot of talk this week about an inverted yield curve and signs of a recession. Here are some thoughts on these subjects that I think are important to know:
What is the Yield Curve?
The Yield Curve is a plot on a graph of the interest rate yields of all US Treasury debt securities. The US Treasury sells debt securities in the form of bills, notes and bonds. When an investor buys these securities, they are expecting interest payments until a maturity date in the future when the initial investment is paid back. These maturities go from 4 weeks to 30 years. As investors, we want to be paid more if we lock our money up for a longer term. This means that the yield curve should be upward sloping from left to right showing interest yields going higher as the maturity gets longer. (See my sketch below)
This past month, we experienced an inverted yield curve which means that the rate on 2-year treasuries was higher than the rate on 10-year treasuries. The image below shows the trend of these rates since May (Source: www.cnbc.com/2019/08/27)
People are concerned about this because an inverted yield curve has been a strikingly accurate predictor of recessions. In fact, going back to 1955, there has been an inverted yield curve before each recession, with 2 false signals. That being said, it is difficult to know when a slow down will happen and on average there tends to be at least 18 months of growth after an inverted yield curve.
What is a recession?
A recession is a slowing down in economic growth. This slow down is typically evidenced in reduced manufacturing and output, slower home building and sales, slower retail sales, higher unemployment, etc. As investors, it is important to understand that the business cycle is cyclical and industries and companies will have different results depending on how the business cycle affects them. The infographic below explains the business cycle and shows a projection of where the major global economies are in the cycle:
Sticking to a Plan
Anytime, there is concern about a recession, it is natural to be worried about the market. However, as investors we should stick to our investment policy. The money that we put at risk should have time to move through the business cycle and we should be properly diversified to sectors and industries that can exhibit strength when cyclical sectors are weak.
In fact, there is still a lot of good news right now. Borrowing money is still very inexpensive, consumers are spending money and the housing and labor markets are going strong.
I came across the interesting graphic below that I thought had some insight into our current worries about a recession. This shows a study of market results after the Fed initially cuts rates, which they just did. What we learn is that even when the economy falls into recession, the market advances half the time with an average return of 7%.
Of course, past performance is never an indicator of future results, and it will be interesting to find out what the next few years will bring. With a late business cycle, a coming election year, and widely debated political agendas from tariffs to student debt forgiveness, there will be a lot of outside factors that the markets and economy will be responding to. We can't plan for things that are out of our control, so whenever the news gets too loud, just reach out and we can talk through it.