With all the news about Brexit and trade, the yield curve has fallen off many investors' radar screens. However, all the selling and political drama of last Thursday obscured a major development for the yield curve that may shift the outlook for late 2019 and 2020.
For those of you unfamiliar with what the yield curve is, imagine a graph with the y-axis representing the interest rate of different types of Treasury bonds and bills and the x-axis representing the time to maturity for those bonds. Normally, interest rates or "yields" rise with longer-term bonds: that's what the "yield curve" normally looks like.
Longer-term bonds are riskier than short-term bonds because there is more time for inflation to rise and eat away at your principle. However, once in a while, the yields start to look very similar; sometimes, long-term interest rates might even fall below very short-term rates.
When long-term rates are lower than short-term rates, the yield curve is "inverted," which is a signal that has preceded recessions in the past with remarkable accuracy. Last Thursday, investors shifted the yield curve much further into inversion territory than we have seen since the last recession. I think worries about the trade war are mostly to blame.
In the following chart, I have subtracted the shortest-term interest rate (the overnight Fed funds target rate) from the 10-year interest rate. As you can see, that comparison has been flirting with negative territory for a few months, but it dropped below 0.00% quickly on Thursday.
Why the yield curve inverts is difficult to explain, but one reason could be that investors aren't worried about inflation because they think future growth will be low. This is one of the most common explanations you will hear from analysts discussing the yield curve in the news.
Another factor that can drive the yield curve into negative territory is if the Fed is expected to lower the short-term interest rate target. Bond investors will buy long-term bonds to keep the average yield within their portfolio high, which ironically raises the price of those bonds and lowers the yield preemptively.
The following chart is compiled by the CME Group and is derived from bond futures, helping traders quantify the current estimate for the Fed cutting the short-term target rate. The current target is 2.25% to 2.50%, but only 42% of investors think it will still be at that level by October's Fed meeting. The majority of investors expect the Fed to cut that rate to 2.00% to 2.25% or lower by the fall.
What to Expect
Some analysts argue that the yield curve inversion is "different this time" because the Fed has been so active in the market since the 2008 financial crisis. However, international bond indicators are tracking pretty close to what I can see with U.S. Treasury yields, which seems to invalidate that theory.
However, even if you still expect the yield curve to be an accurate signal of economic downturns, there is an important caveat with the yield curve signal – it's usually very early. An inversion appears 10 to 18 months prior to a recession on average, and the last one was almost two years before the 2008 financial crisis. What that means is that, although the signal appears to be worsening, investors likely have quite a runway remaining before the market will get too sketchy.
The S&P 500 moved higher another 17% from the last inversion in 2006 before reaching its ultimate peak in 2007. I am making this point because it is important to think about the market as a gradient between extremes of entirely bullish or completely bearish.
Studies have shown that the reason most individual investors perform poorly in the market is because they get out too early at the first signs of trouble and then wait too long to re-enter when everything seems to look perfect. However, by definition, the top in the market occurs at the point of maximum optimism, not the point at which investors are most pessimistic. The opposite is true for market bottoms.
Bottom Line – Think about Risk as a Gradient
A market holiday is a good time to think about issues like the yield curve while there is no pressure to act. My suggestion is for investors to start becoming pickier about their investments by paying closer attention to fundamental growth trends and relative strength but not to flee from taking risks. As we get a little closer to second quarter earnings season, the outlook for which sectors and groups are likely to outperform if the market is getting closer to a top in 2020 will also look more clear.
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