The Effect of an Inverted Yield Curve on Your Portfolio

Last week, when the Dow fell 800 points on news of an ominous signal from the bond market, several AMDG Financial clients reached out to us for guidance. “Should I change strategies?” some asked. Others wondered if they should get out of the market altogether. Our clients weren’t alone: The CBOE volatility index, or VIX, often called the “fear index” because it measures 30-day forward-looking volatility, jumped nearly 27% last Wednesday. News reports everywhere predicted enough doom and gloom to send many investors running for the exits!

What Started the Panic: An Inverted Yield Curve

You may have heard something about a “yield curve” in the news, but may not know much about it. Here’s the scoop: The yield curve has to do with the performance of government bonds. The curve provides a snapshot of how yields compare across bonds of similar credit quality, but with different maturity rates (think three months, one year, five years, 10 years, etc.) at a specific moment. Much of the time, the curve slopes upward, with long-term bonds offering higher returns than their shorter counterparts. Last week, however, the opposite happened: the 10-year Treasury bond yield fell below the yield of the two-year Treasury bond. This is called an “inverted” yield curve.

What’s so spooky about an inverted yield curve? According to research by several authors, including Nobel-prize winner Eugene Fama and Kenneth French, an inverted yield curve tends to be a harbinger of a future recession. In fact, a recent paper by the Federal Reserve Bank of San Francisco found that every recession between January 1955 and February 2019 was preceded by an inverted yield curve, and that the delay between the inverted yield curve and the beginning of a recession occurred within a two-year period, as soon as six months after, and as late as 24 months after. It’s natural to wonder, then, given the pattern, how to prepare for bad times ahead. Does an inverted yield curve mean low stock returns?

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What the Evidence Tells Us

Last month, Fama and French, who are also consultants to, board members of, and shareholders in Dimensional Fund Advisors (DFA), released their first draft of a paper on inverted yield curves and expected stock returns. In it, they tested whether the fear of low stock returns after an inverted yield curve is valid. Their conclusion? There is no evidence to show that inverted yield curves predict stocks will underperform T-bills for forecast periods of one, two, three, and five years.

A 2018 paper by DFA makes an additional important point. The article explores what happened when an inverted yield curve occurred just prior to the 2008 financial crisis. According to the paper’s authors, the U.S. yield curve inverted in February 2006. In the following 12 months, the S&P 500 posted a positive return. The yield curve also became positive again in June of 2007, four months before the major downturn that occurred in October 2007 and lasted through February of 2009. DFA makes the point that if an investor had decided to get out of the market after the yield curve inversion, he or she could have missed out on the stock market gains that occurred during the lengthy period before the financial crisis. (The article also points out that if the same investor bought more stock when the yield curve turned positive, he or she would also have been exposed to the market weakness that occurred later.)

What to Do

As the yield curve inverted last week and people began to worry about a future recession, not everyone is convinced that history will repeat itself. Former Federal Reserve Chair Janet Yellen told Fox Business Network that “there are a number of factors other than market expectations about the future path of interest rates that are pushing down long-term yields.” Indeed, the trade war with China and a tight U.S. monetary policy could affect the market too; however, the U.S. economy remains strong, strengthened by robust employment numbers and wage growth, record corporate profits, and favorable consumer activity.

Could a recession happen? Sure – but when? And how would an investor be able to predict when to safely get out of the market and back in again without losing returns?

When we work with our clients to create long-term investment strategies to achieve their goals, we know the markets will certainly encounter various ups and downs along the way. We also know that by focusing on the evidence and not on our emotions, we’re more likely to help our clients realize a successful investing experience. If you have questions about market news and its effect on your portfolio, we’d be glad to answer them anytime. But for now, my best advice is to focus on your goals instead of on news headlines. As the saying goes, this too shall pass. 

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