JUST PLAIN TALK: A primer on the inverted yield curve
Pundits recently made journalistic hay with their pontifications on the bond market’s inverted yield curve. While it sounds esoteric, the bond market is essential, and people should pay attention. Inverted yield curves have preceded the last five recessions. However, commonality is not causality. Former Fed Chair Janet Yellen argues this time it “doesn’t signal that this is a set of developments that would necessarily cause a recession.” One of the best explanations about how the yield curve works was on Twitter by Heidi N. Moore (@Moorehn) — she gets bonus points for blocking any yield curve “mansplainers.”
The stock market garners all the press, but the 800-pound gorilla in the room is the bond market, think trillions of dollars. The stock market may be the candles while the bond market is the cake. Bonds are debt that companies, municipalities, and governments issue to finance operations. Bank certificates of deposits (CD) are like bonds. You buy a CD, and the bank returns your money with interest; it’s the same with bonds. A company often secures it’s debt by real property or other tangible assets while municipal debt can have dedicated tax revenue for security.
Debt with a 10-year maturity should logically have a higher yield than one with a two-year maturity. An investor should be compensated for having their money tied up for a more extended period. Generally, returns follow an upwardly sloping curve, rising as maturities lengthen. When municipalities or state governments issue debt, the yield is often lower on shorter maturities versus longer-dated ones. Governments often issue municipal bonds with “early call” dates so higher-yielding debt can be paid off sooner and minimize taxpayer obligations.
Last November, U.S Treasury 10-year notes were trading with yields as high as 3.25% but by mid-August yields collapsed to less than 1.5%. The steep decline meant 10-year Treasury notes, held to maturity, were trading lower than their two-year brethren. Last March, the yield on the 10-year Treasury notes dipped below the return on three-month Treasury bills. Instead of the routine, upwardly sloping yield curve, it is instead upside-down or inverted.
A yield curve that’s relatively unchanged from short-term to long-term is a clear signal bond investors believe the U.S economy is on the downswing. Bond investors don’t like uncertainty. Unlike municipal and corporate, U.S Treasury debt only has the full faith and credit of the United States government, which is pretty powerful. Unlike most nations, we have never defaulted on our debt. Despite what some say, China and other countries exporting to the United States don’t pay tariffs, Americans do. Record high federal debt levels coupled with historically low-interest rates leave few tools for the Federal Reserve to combat a potential recession. To paraphrase Benjamin Graham, Warren Buffett’s mentor, in boom times or recessions, your portfolio should maintain a margin of safety.
You can’t always get what you want but Buz Livingston, CFP can help you figure out what you need. For specific advice, visit livingstonfinancial.net or drop by 2050 West County Highway 30A, M1 Suite 230.