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Our Take on the Inverted Yield Curve

As we head into Labor Day Weekend 2019, interest rates are doing strange things around the globe. In many countries, including Japan and large parts of Europe, government bonds are now sporting negative yields. Stranger still, in Denmark there are now mortgages with negative rates — yes, you get paid a little bit for borrowing money to buy a house!

Here in the US, things are comparatively normal, except for one thing: yields on US Treasury bonds have inverted. What this means is that longer-term bonds are paying out less than shorter-term ones. Bond yields as of August 28, 2019 are as follows:

30-Year Treasury yield: 1.92%
10-Year Treasury yield: 1.45%
2-Year Treasury yield: 1.49%
3-Month Treasury yield: 1.99%

As you can see, 3-month Treasury bills are yielding more than 10-year bonds and even 30-year bonds! This is not normal, because longer-term bonds typically pay more since they mature many years from now.

Why is this inversion spooking the markets? Because prior to past recessions, the yields on longer-term Treasury bonds have fallen below the yields on shorter-term bonds. Why does this happen? Honestly, this isn’t entirely agreed upon, but there are some pretty good hypotheses out there. Primarily, it is agreed that yield inversion reflects market concerns that the economy might be slowing and that the Federal Reserve will then be lowering its key interest rate (the Fed funds rate) to counter the slowdown.

How good a predictor of recession is yield inversion? Dating back to the early 1970s, an inverted yield curve has consistently occurred before a recession materialized. However, an inverted yield curve isn’t the most timely of indicators. The most widely cited measure for inversion is the difference in yield between the 10-year and 2-year Treasuries. Typically, a recession has occurred 12 to 18 months after the yield curve first inverts. And generally, the inversion deepens before normalizing. So although the yield curve has now officially inverted, a recession could still be quite a ways off.

Here at LNWM, we do consider the yield curve along with many other fundamental data to arrive at our outlook for the economy and determine portfolio positioning. The bulk of our research doesn’t suggest a recession is imminent, so we haven’t made dramatic changes to portfolios. Nevertheless, we have reduced risk on the margins by increasing cash and core fixed-income positions and are likely to continue to take steps in that regard as we go forward.