The yield curve rightly predicted the previous seven US recessions. And it is about to wave the red flag again. Though stock markets may indicate record price highs the yield curve prediction of a recession should be considered more stable and accurate.
What Does The Yield Curve Indicate?
The plot of the yield curve tracks the short term bond rates, for
example, the 2-yr Treasury yields versus the ten-year rates. The current 10-yr
yield is at 2.98% lagging the 2-yr rates of 2.62% by a mere whisker of 0.36%.
Such narrow differences have never been noticed
for over a decade.
When the yield curve inverts, it spells huge problems as it indicates the short term bond rates are better than the long-term rates. It is this change that marks a recession and has been the precursor of the last seven US recessions. With the gap nearing inversion it could only spell a recession in a year’s time as has occurred in all seven instances before.
How Will It Impact The Bonds?
Ideally, a healthy economy is indicated when the long-term bonds yield more than short-term bonds. The bonus of a higher rate for savings and investments in the long-term Treasury bonds means lack of access to funds for more extended periods of time and this is made up for by offering higher yield rates. Both the investors and the Treasury are in a win-win situation with liquidity for the treasury and a better yield for the investor.
When the yield curve is moving towards inversion investors, have no impetus for saving in long-term Treasury bonds because of the falling interest rates. It is quite reasonable that during a recession period interest rates will fall. Factors like less competition for borrowed money, weak business environment, fewer home buyers and fewer industries investing in machinery and equipment also contribute for such fall in yield prices.
It is not the contribution of the financial markets alone that has led to this situation. The Federal Government has added to the woes of the current situation by hiking the yields on short-term bonds twice in the fiscal year. Thereby the government hopes to curb inflation. But Wall Street and the bearish financial markets have held-down the rates of the long-term bonds due to weak growth on the economic front. Working in tandem, the two-dimensionally opposite actions has led to a flat curve which will lead to the inversion of the curve if the Federal Government hikes the short-term rates twice more in this year as anticipated.
How Will It Impact The Stock Market?
The yield curve is yet to invert. In reality, the flatter curve is
a prediction of the slowing down of economic growth. A recent study by
BMO-Capital-Markets showed that when the rate difference fell to below 0.5% and
the yield curve did not actually invert
there was no major impact on the stock
markets. It also showed that stocks bettered their performance during the flat phase rather than when the rates drew
apart steeply, and the curve rose to
indicate the same.
What Can You Do?
Check your risk levels in your portfolio and ensure your bond-to-stock ratio is a balanced risk. Don’t worry about the recession. Cut your losses with a better 50 to 50 spread over bonds and stocks. It is a red flag and caution is advised. Though hopefully, the recession will not be as bad or severe as the previous one. Wait it out and play safe.