The Inverted Yield Curve

The yield curve is a graph of the interest rate on bonds as a function of time to maturity. Normally, long-term interest rates are higher than short-term interest rates to compensate for the greater riskiness of the unknown. But sometimes, the situation reverses, and short rates rise above long rates, and the yield curve is said to be inverted.

The Inversion

As a quick caveat, short rates are set by the Federal Reserve. So when the yield curve is inverted, investors expect the Fed to be loosening monetary policy in the future. Investors therefore are willing to hold long-term bonds, despite the lower current yield, because they are locking in the lower yield in the future.

The perception of an upcoming economic slowdown leads to an inverted yield curve today. That is why the slope of the yield curve is one of the leading indicator variables. While the ability of the yield curve to predict a recession is pretty good, it is inherently stochastic in nature, and therefore, far from perfect.

It is crucial to be reminded that the Fed looks at the economic activity in conjunction with inflation. So the yield curve also reflects investors' perception of inflation trends. An inverted yield curve suggests higher near-term inflation resulting in deleterious effects on the economy, which then prompts the Fed to lower rate in the future as the economy gets impacted by the inflation induced slow-down.

Cool Tricks to Save Some Do'

For your short-term income needs, choose the investment with the highest yield, but keep in mind that inversions are an anomaly and they don't last forever. When the inversion ends, adjust your portfolio accordingly.

Consumer staples and healthcare sectors, which are not interest-rate dependent, are the most immune to inverted yield curve shocks. Defensive sectors, such as food, oil and tobacco, are often less affected by downturns in the economy. Purchasing Treasury-backed security also provides a yield similar to the yield on junk bonds, corporate bonds, real estate investment trusts (REITs) and other debt instruments, but without the risk inherent in these vehicles.

For you personally, locking in lower longer-duration mortgages makes greater sense than going for higher rate ARMs. Specifically, if your ARMs are now floating rate, it makes sense to covert them to a lower rate longer duration fixed interest mortgage.

Last Word

Keep in mind that history is littered with portfolios that were devastated when investors followed predictions about how "it's different this time" without question. Most recently, shortsighted equity investors spouting this motto participated in the "tech wreck," snapping up shares in tech companies at inflated prices even though these firms had no hope of ever making a profit. A reminder of exactly what happened in 2000 and 2008.

Stay safe, stay nimble, stay humble!