Does the Yield Curve Inverting Mean a Recession is Coming?

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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
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The past few days have been filled with breathless media reports, all of which admittedly sound scary.

“Yield curve inversion: recession sign sparks panic”

The panic over yield curve inversion, explained, Vox.com

 

Now that one of the most reliable recession indicators in the market got triggered, investors across the globe are starting to worry if this could mean the U.S. economy is slowing down.

The US bond yield curve has inverted. Here’s what it means, NBC

That’s because on Friday, March 22, 2019, the US Treasury yield curve inverted. And because the yield curve inverting has historically signalled an upcoming recession, this sent everyone into a panic. The markets dove that same day with the Dow dropping 300+ points.

What is the Yield Curve?

Before we get into this, let’s talk about the yield curve and what it means.

The US treasury issues debt in three basic forms:

  • Short-term maturities of less than a year (Treasury bills)
  • Medium-term maturities between 1 year and 10 years (notes)
  • Long-term 30-year bonds

When you hear news stories about interest rates rising or falling, they’re almost always referring to the federal target rate, a number set by the Federal Reserve, or rather the Federal Open Market Committee (FOMC) which operates under the Federal Reserve system.

This rate has the most direct effect on short-term lending rates. The interest rate on longer-term debt such as notes or bonds is set by the market, meaning that even if the bond is issued with a certain interest rate, if bond traders refuse to buy that bond at that price, then it doesn’t matter. The effective interest rate is determined when someone actually buys it at a certain price, and the lower the price it gets purchased at, the higher the effective interest rate.

To make this a little more concrete, remember that Greek debt crisis that happened a few years ago when it looked like the Greek govenment was going to melt like honey melts into a bowl of delicious delicious Greek yoghurt?

Photo By Randall Whitmore @ Flickr

Wait, what was I talking about? Oh yeah, bonds.

Anyway, the Greek government issued bonds back then, but surprise surprise nobody wanted to touch the stupid things. So those bonds only sold at really low, fire-sale prices, which had the effect of spiking the yields on their debt. At the worst of the crisis, investors had so little faith in Greek bonds that they’d only touch them if they were paying a yield of almost 15%! 

Anyways, back to the US. Each maturity has its own interest rate. The shorter ones are set by the FOMC, and the longer ones are set by the market. If we were to plot out these interest rates on a chart, it would look like this.

Photo By Ldecola @ Wikipedia.org

This is a normal Yield Curve. The yield on short term debt is, again, set by the FOMC, and goes up as maturity increases. This makes sense, since it means the bond investor is locking their money away for longer. After all, you wouldn’t buy a 5-year CD or GIC unless it was paying a higher interest rate than a 1-year, right?

Here’s where we are now.

Yikes. What’s going on here? We would say parts of the yield curve have inverted, meaning some longer-term maturities are yielding less than shorter-term ones.

What Does This Mean?

Remember, when it comes to fixed income, yields are inversely proportional to price, and price is a proxy for demand. That means when yields fall, demand for that maturity has spiked which is what led to its price increasing. And when yields spike (like in the Greek situation), that means nobody wants it unless they can pick it up for fire-sale prices.

So what we’re seeing here is a drop in yield and a spike in price (and therefore, demand) in the 3-to-10-year range.

Why did this happen?

In short, the Fed announced on March 20 that not only were they going to not raise interest rates, but they were going to stop raising them for the remainder of the year.

This surprised the Hell out of everyone, because at the beginning of the year everyone was expecting the Fed to continue raising interest rates throughout the year. The big debate was not if, but how many.

So this surprise reaction had an immediate effect in that it caused demand to plop for short term debt and investors to flood into longer term issues.

To investors just learning the ropes, I generally advise they just hold their fixed income assets in a aggregate bond index ETF such as VAB (Canada) or BND (USA) (see our investment workshop for details). 

But some investors like to hold their bonds in a short-duration Bond ETF like Vanguard’s VSB. Why? Because when central banks change interest rates, the price of bond ETFs change as well, and you can measure how sensitive a particular bond ETF is to interest rate changes using a metric known as “Duration.”

Remember that bond prices move in the opposite direction as interest rates, so when interest rates go up bond ETF prices go down and vice versa. Exactly how much is given by this “Duration” metric, and how it works is if an ETF’s duration is, say, 5 years, then a 1% interest rate move upwards will cause the bond ETF’s price to go down 5%. Conversely, if interest rates drop by 1%, this bond ETF’s price will go up by 5%.

You can look up any bond ETF’s duration by checking out their prospectus, or more commonly just looking at the fund’s web page. Here’s VAB’s ETF page on Vanguard’s website, and its duration which is currently listed as 7.6.

If you find any of this confusing, don’t worry, you’re not alone. Bonds are a confusing topic. I’m not going to ramble and get lost in the weeds here because I’m trying to make investing LESS confusing, not more! But basically if you think interest rates are going to rise it makes sense to hold your bonds in shorter-duration, shorter-maturity issues because this blunts the negative impact on its price as interest rates rise. VSB, for example, has a duration of just 2.6.

But when interest rates no longer rise? Then it makes no sense for investors to hold short-duration bond ETFs. It makes more sense to dump them in favour of medium-duration ones like VAB, which is the Canadian Bond Index ETF I advocate in our Investment Workshop.

This is what I think happened. Bond traders took one look at the Fed’s announcement and collectively went “Hey, why the Hell am I giving up yield holding short-duration bonds if interest rates aren’t going to rise anymore?” and flooded into medium-term issues, increasing demand and dropping the yield at the 3-to-10-year part of the Yield Curve.

Are We Headed for a Recession?

Now here’s where I have to caution that I’m doing exactly what I’m NOT supposed to do and making a prediction. And also remember that I’m just some blogger and not, say, a former chairman of the Federal Reserve.

But what I honestly think is: No.

You always have to be careful when an indicator like the Yield Curve inverting gets triggered. You have to ask yourself: Why is the indicator being triggered, and does it mean the same thing as in previous situations where a recession did happen?

In most pre-recession yield curve inversions, it’s caused by bond traders flooding into longer term securities because they believe that a rate cut may be on the horizon. Remember, if rates get cut, bond prices will rise, and the bonds with the longer durations are going to rise more than bonds with shorter ones.

So a yield curve inversion is basically the bond market betting on a rate cut, and normally the only reason that rates would get cut is because something horrible is going wrong with the economy.

We’re not in that situation. The Fed didn’t decide to pause their rate increases because the economy is dropping off a cliff. They did it because of political reasons.

For the past year, Trump has been screaming at Federal Reserve chairman Jerome Powell for increasing interest rates. Increasing interest rates, by the way, is exactly what the Fed is supposed to do during economic expansions because it keeps inflation in check, but Trump being Trump was worried that interest rate increases were hurting the stock market, which he’s been using to brag about how great he is. So he’s been threatening to fire Mr. Powell in the news hoping to pressure him into stopping his rate increases.

He’s REALLY not supposed to do that, by the way, since the central bank is supposed to be politically neutral and independent from the rest of the government, but you know, it’s Trump.

So I see the decision by the Fed to halt interest rate hikes as not an economic decision, but rather a political one. And that’s why I don’t think this Yield Curve Inversion means a recession is coming in the US.

Now again, I’m just some blogger and not a former central banker. But in my defence, Janet Yellen, the former central banker, is on my side saying she also doesn’t think a recession is looming either.

But hey, what does she know, right?

What do you think? Is a recession coming? And if so, what are you doing about it?


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51 thoughts on “Does the Yield Curve Inverting Mean a Recession is Coming?”

      1. There could be deeper winter, or less Winter. Or maybe a mild chill? There are lots of winters. There is always once coming.

        Is your “no recession” prediction for the whole year? For the next month?

        Awesome article

  1. If I knew a recession was coming, I’m not sure I’d do anything differently than I am now; my job is fairly stable, my wife’s job is even more so, we could live on one income easily, and we have contingency plans for at least a year if we both lose our jobs.

    But holy hell it sure would hurt the folks who voted this loon into office. I feel kind of concerned about that — mostly because if they believed him in the first place, and they still believe him now, they’ll believe him when he blames this all on someone else.

    1. Yeah, for someone like you in a stable job a recession is just a time to buy more index funds at fire-sale prices. You’ll be fine. The rust belt…not so much.

  2. Fed has signaled no more rate hike in 2019. There are speculations that Fed may reduce interest rate later this year as the global economy is heading south. If this is the case, the interest rate will maintain on a low level. In case of something bad happened, Fed doesn’t have much choice/weapon but to push interest rate to the negative level.

    In view of the potential recession and the possibility of negative interest rate, have you thought about how do the FIRE practitioners maintain sufficient income to pay the bill. Any thoughts or insights to share? Thanks.

    Regarding whether recession is coming, besides the inverted yield curve, we could also take a look at the GDP of those major countries.

    UK reduces the GDP forecast from 1.5 to 1.3 within 2 months.
    Germany GDP forecast was reduced from 1.8 to 1 within 5 months.
    France GDP forecast was reduced from 1.8 to 1.25 within 8 months.
    Italy GDP forecase was reduced from 1.20 to 0.1 within 7 months.
    Japan GDP forecase was reduced from 1.1 to 0.7 within 5 months.

    Inverted yield curve is not the root cause. Instead it is a symptom of economy slowdown globally. Global economy slowdown could be one of the reason why the Fed stops rate hike this year. I am not economist myself. However based on these fact, for sure we are not in an expanding cycle. If the economy is not doing well, corporate earning will suffer as a consequence. When earning per share cut, the stock price will be affected. Whether we fall into the definition of recession, we could leave it to the economists.

    1. If it happens, Yield Shield + Cash Cushion + Geo arbitrage baby! I’ll be sipping mai-tais on a beach and ignoring the news.

      I don’t think we’re there yet, but that’s my plan.

  3. Thanks so much for explaining this so clearly! I had a high level idea of what a yield curve inversion meant, but this helped me ACTUALLY understand it so thank you so clarifying complex topics as always. As for if a recession is coming: I have no idea, but I wouldn’t change anything if it was. It would push my retirement date from the 17 month countdown I’m currently looking forward to, but probably only by a few months 🙂 . Staying the course!

    1. Glad to help, and yes staying the course would be the right thing to do. Even if a recession is coming (which I don’t think it is), the timing of it nobody knows.

  4. Yes I too was surprised that the fed reversed course on interest rates. Is the correction coming soon? I will confess that I am defensively positioned but this does not mean that I am sitting on a pile of straight cash and trying to time the market, it just means I am not fully in the indices and working hard for below average yield in other areas. The fed as well as a bunch of investment managers that I respect are all saying slowed growth is the current prediction. I hope that they are right and the markets don’t seem to be moving hugely from the inversion so far (just that first blip). My opinion is that when a correction will happen all comes down to either a big change in consumer sentiment, or a big event that affects markets and creates the former which then causes the correction to unfold. I know thanks captain obvious right?

    1. Well, they say the 2 main reasons for a recession are:
      1) The Fed raising interest rates too fast and causing a contraction or
      2) An exogenous shock nobody sees coming

      #1 is obviously off the table, and nobody can predict #2.

  5. Well, we know a recession is coming, we just don’t know when! Given the longevity of this bull market (2nd longest since WW2) and an average PE ratio of 21 (when 16 is the norm) it would be reasonable to say that a recession is “overdue”. Does that mean one is coming in the next 12 months? No one really knows.

      1. Hey Gazza – I just Google PE Ratio for S&P 500 and it’s like the 1st thing that comes up. You can also see how today’s PE ratio compares to historical PE ratios and that 90% of the time the PE ratio is lower than it is today. It portends that stocks are quite expensive these days.

    1. Not that it changes the point you’re making, but is that CSE or US markets? I thought that as of August 2018 US markets entered the longest bull market in history? Either way I agree with your general point.

    2. The length of a bull market is in no way a sign of a recession. A recession, in every instance, was caused by something, and in every instance it was never because it was “overdue”. Not trying to be have a rude tone. All I’m saying is don’t get too wrapped up in thinking it will happen because it is bound to happen. It could be 5 or 10 or even 20 years from now.

  6. People have been expecting a recession due to the end of the 10-year cycle running up and developments like trade wars certainly don’t help. Yellen had a point but we can’t ignore that a fair number of economists (e.g. Paul Krugman, Robert Shiller) are seeing higher probabilities of a recession coming. Self-fulfilling prophecy might even push the recession closer. Regardless of what the outcome will be, I think we should all prepare ourselves for one by bumping up our emergency savings, refreshing our resumes, etc. I published a detailed post on recession prep on my blog this morning.

  7. Great explanation of the yield curve Wanderer, but your prognostication about the turn-around in rate increases being politically motivated is pure speculation.

    Powell is *not* the dictator of the federal reserve. He’s the appointed chairman. The FMOC regularily meets and votes on monetary policy. There are 12 voting members, not all of which are appointed by the president.

    I’d also like to quote this section from the Federal Reserve Board, “Once appointed, Governors may not be removed from office for their policy views…”

    To put this frankly, Trump does not have the authority to fire Powell.

  8. I am leaning towards Canada entering hardcore recession over the next 18 months. Household debt is wayyy too high. The provinces are acting more like isolated independent nations than regions that are part of one country, both politically and geographically. The political gridlock of trying to please everyone is causing foreign capital to flee to more lucrative regions of the world. Housing is still hella over-priced in major centres, and there is no happy way to bring prices back down to earth without screwing over individuals with most of their net worth tied up in real estate. Boomers are retiring, and if they have not already downsized they are at risk of losing their nest egg. Boomers returning/staying in the workforce hinders younger workers from finding well paid work and thus being able to pay for boomer real estate. Too many people I talk to (half) are still living paycheque to paycheque, and most have household incomes well over $100 000 CAD/year. Too many households have collective debt that is greater than their assets. If they are under 40, their houses were purchased with 5-20% down, and after 5-15 years of ownership are still holding the same or more mortgage debt as when they started due to consolidating debt. They have credit card debt that is only fully paid off once or twice a year, if ever. They have lines of credit that never go away. They have car payments. They have children enrolled in too many programs. They have no real savings other than RESPs for their children and sometimes tiny mutual funds that do not keep pace with inflation. This is HALF of the people I have personally discussed fiances with here in Alberta. It is even more nutty when I talk to people in BC or Ontario.

    That was me 2005-2012; I started with $250 000 CAD 5-year fixed, and sold with a $280 000 CAD HELOC. My opportunity cost was +$100 000 CAD of money that would not have been spent on living costs had I continued renting, plus whatever yield that money would have paid when properly invested. You can double that amount when calculating lost wages had I worked paid hours instead of (very literal) unpaid hours renovating my property. Thousands of hours (~3600 h). I paid full taxes instead of contributing to my RRSP and other tax shelters I had set up, because I was drowning in growing debt and unable to save a single dollar.

    Parents told me to buy as soon as possible…..parents who themselves are incapable of retiring and continue to make poor financial decisions.

    I Mathed Shit Up. My old rental location was and still is $750 per month for two bedrooms, utilities included, mountain view, a few hundred hectares of city park in front, LRT nearby and lots of parking. I would have reached fire in my early 30’s. Unfortunately FOMO and parents convinced me to take another path.

    After I ditched the house, I was able to travel the world for 5 years, save money while doing it, and have never been happier. Now that I have returned to Alberta, I am in shock at how many people of all ages, have grown their debt, and financial independence is further away than ever before for them. People I know in their early 20’s are buying real estate with 5% down, living without room mates, buying new oversized vehicles and all the latest tech gadgets…..because their parents told them to. They are drowning. They have to borrow money to cover their payments. They have degrees and work for big corporations.

    Every week, I see another empty storefront or office floor, industrial yards full of parked rusty heavy equipment, in every town and city in Alberta (Banff and Canmore excepted). The dominoes are already in motion, Canada has just not felt it yet.

    1. CANADA might, absolutely. Our household debt is insane, and to be frank I’m surprised it hasn’t happened already.

      That being said, Canada just keeps trucking along for some reason despite getting whacked with economic shocks like NAFTA renegotiation and the oil price crash. Not sure why.

  9. “But what I honestly think is: No.”

    Hey Wanderer. I love your blog and am a religious reader. But with all due respect, your messaging here is foolish. Plain and simple. I’m not saying a recession is coming with 100% probability. But to deny that the probability of a recession in the near-term is materially higher today than it has ever been in the past 10 years is downright foolish.

    Just look at the data. Google the St Louis Fred’s data on the 10yr vs 3-month yield curve and you’ll see that a negative spread has preceded 100% of recessions over the last ~37 years within a ~6-18 month period. That’s 3 for 3 with NO false positives. What is the 10yr vs 3-month spread today? Negative 7 basis points. Yes, that’s negative.

    To deny that historical market data on the multi-trillion dollar interest rate markets, and to conclude that “this time will be different” is downright foolish.

    I’m by no means saying that there is a 100% probability of a recession. Or that a recession is even coming in the next 12 months. But the data implies little doubt that the risk of a recession is materially higher today than it has been at virtually any time in the last ~10 years.

    Covering your eyes and telling yourself otherwise will not change that fact.

    1. An inverted yield curve has preceded every recession, but every yield curve inversion does not necessarily precede a recession. There have been false positives before, and I think this is one.

  10. Read an interesting article the other day that analyzed average market performance after all the different yield curve inversions in recorded history.

    It seems like on average whenever inversion is followed by a recession (which isn’t always guaranteed either), the recession usually happens a year or so after the inversion. Also, that year-ish period between inversion and the coming of recession usually brings kick-ass, bumper-crop equity market returns.

    The article discussed how the typical historical pattern of Fed behaviour leading up to and through inversions was to halt rate increases or even resume rate cuts due to being freaked out about the state of the economy / markets. That would cause the inversion and at the same time stimulate the equity markets for a year so, at which point the Fed would get freaked out about the inflation and resume tightening, over-tighten and cause a recession. Those who see recession over horizon think it may not even get to the over-tighteining-freakout phase this time, as Fed may start cutting now and run out of any more space to cut by the time recession arrives.

    Anyway, all I am saying is: even if the worst case comes true and recession really is coming, if a similar historical pattern plays out, we should still get a year or so of good market performance before it hits. So 2019 may well turn out to be a “party-on” year for everyone’s portfolios.

    Just another thing to ponder for those needing cheering up from all the media doom and gloom about the inversion.

  11. I do believe a recession is coming.

    When has the federal reserve ever predicted a recession? Don’t forget they employ over 300 PHD economists and did the fed say something was wrong in 2007/2008?

      1. This recent BusinessWeek article points to the fact that economists generally fail at predicting recessions, by a large margin. As a previous economist myself, I generally track what some of the more popular and “famous” economists say and wonder why none of them have ever had a mea culpa moment after they’ve gotten things very wrong? https://www.bloomberg.com/news/articles/2019-03-28/economists-are-actually-terrible-at-forecasting-recessions

        I guess it’s most prudent to always be prepared. Like a financial boy scout. You should start an academy and give out badges for proving adept at finance-related skills, lol.

  12. No recession this year. There is however the coming economic earthquake with the growing debt over 22 Trillion, half of Americans have no retirement savings and SS and Medicare will be running out of money. But not to worry, no recession this year.

  13. Wanderer I switch to short term bonds VSB instead of XBB I had at the time, thinking I was smart as interest rates were going to rise. Well first I learned as I am sure you would say it is hard to time and I probably switched too early. Second the rule of rising rates causing bond loses proportional to the duration did not work out. Turns out it is not that simple. Compare the returns of these two over the last 3 years.

    So I have learned that timing never works and although this has had a minor effect on my overall returns and will not ruin my retirement plans I think the lesson I would share is just KISS and ride the broad bond fund (XBB or VAB) and ignore duration and rates.

  14. IF a recession is imminent and signs can be seen everywhere, personally I will be increasing my cash emergency account. Typically in a recession, people lose jobs or get their hours cut and since recessions usually last a couple of years, I would rather have enough money to cover those years when my portfolio value is falling.
    And keep investing in my portfolio regardless of what’s happening as I have a long way to go before retirement and the recession will end eventually.

    1. A huge recession was allegedly going to be the result of his first term. People just don’t want to believe that attempting to delineate the global macro-economy into arbitrary and discrete units, like presidential terms, is a losing proposition. Stop trying to predict the future based on omens selected through confirmation bias and simply work your personal financial plan no matter what.

        1. I have no idea what that is designed to convey. It’s like a wrapped Christmas present; I have no idea what’s on the inside.

  15. Eventually we will get a recession, it’s an inevitably of capitalism, what people aren’t anticipating is the demographic shift and how permanently this next recession will suppress the markets and general economy.

    Think about it you have tens of millions of boomers retiring with meager savings, all will need to tighten their purse strings to get another 20 years , that’s s going to be a drag on the economy.

    I think millennials better prepare for a world with less than 7% average returns.. at least with US only markets..
    on an semi-related note I came across this calculator http://www.abrandao.com/retire/ that does a nice job of telling you how much you may need to retire and weather the coming downturn.

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