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A Note on the Yield Curve

A Note on the Yield Curve

June 10, 2022

Recently, you may have seen some headlines talking about an “inverted yield curve” and what it may mean for the economy.  An inverted yield curve is just one indicator of the economy’s possible direction, so let’s put these headlines into context.

First, what is the yield curve, and what does it show? The yield curve is a graphical representation of interest rates (yields) paid out by US Treasury bonds. A normal yield curve shows increasingly higher yields for longer-dated bonds, creating an upward swing. An inverted curve has a downward slope, indicating that shorter-dated bonds yield more than longer-dated bonds, which isn’t typical.

Does an inverted yield curve mean we’re headed for a recession? Based on the historical track record of this indicator, yes, an inverted yield suggests a recession may be coming. Since 1976, a recession has followed an inverted curve every time. However, there are some important caveats to mention here:

An inverted yield curve needs to remain inverted to be considered an indicator. It’s normal for markets to fluctuate as conditions and investor sentiment ebb and flow. But, according to the experts, for an inverted curve to be a recession indicator it needs to stay inverted for a month or more, historically.

Source: PGIM

Recessions aren’t instantaneous. An inverted yield curve doesn’t mean a recession is just around the corner. Since 1976, the average time between an inverted yield curve and an official recession has been around 18 months; the longest was nearly three years. That’s plenty of time to prepare!

It’s also worth mentioning that an inverted yield curve doesn’t cause a recession. The yield curve reflects bond market sentiment – it doesn’t drive it. The yield curve inverts when bond market investors feel like something may be up and, in response, favor shorter-term bonds over longer-term ones.

It’s a deceptive signal for your portfolio. An inverted yield curve doesn’t mean it’s time to sell! Historically, the market continues to advance following an inverted yield curve, gaining an average of 11.5% real return (net of inflation) since 1976. Don’t let one indicator spook you!

The takeaway here is that while an inverted yield curve may be unnerving, it’s by no means cause to panic. If anything, it’s an opportunity to assess your portfolio’s allocation against your risk tolerance, evaluate your household’s current spending, and potentially increase your emergency fund. Our team is closely monitoring economic conditions and will proactively alert you should we feel action needs to be taken. In the meantime, feel free to call us if you have any questions or concerns.