The Yield Curve Just Inverted… What happens next?
A few days ago, the U.S. 3-month Treasury yield surpassed the 10-year rate for the first time since 2007, inflicting nervousness across the market. Economists typically favor this metric in predicting recessions, with historical figures on the chart below suggesting slumps that occur on average eighteen months after the inversion. As you can see, when the slope dips below 0, subsequent recessions – highlighted in grey – occur shortly after with the last one being the Great Recession of 2008.
The logic behind this predictor is quite simple; long-term bonds should have a higher yield due to the greater risks associated with time and inflation. Healthy inflation typically resembles investor sentiment towards a strong economy, but when the curve inverts it signals the opposite. Basically, the market believes inflation will be low or negative in the near future, as well as economic growth.
This may seem reasonable looking at the current status of the world economy. The Eurozone is a disappointment, with Italy sliding into recession, Germany at risk, and weak numbers across the other major countries. China appears to be struggling at continuing to fuel its expansion and the U.S., despite strong figures recently, is not sure where it’s headed. Strong growth over the last decade since the recession also suggests that we may finally be nearing the end of the business cycle and heading into contraction.
Should we just acknowledge that we will face a recession in September 2020 and hope for the best? A decent chance of recession may exist but buying into the fear is probably the worst response to it. This will lead to the self-fulfilling prophecy phenomenon where investors’ terror about recession causes them to withdraw their funds, causing a massive sell-off , and then a recession actually does occur as the market dries up.
The inverted yield prediction is also flawed due to its unreliability in predicting when exactly the start of a slump is. Eighteen months is an average figure for the start of a recession but in reality, it could be much later or much sooner. The market is akin to a rampant lion; powerful, unpredictable, and impossible to tell where it's headed. We know that there will be a recession in the future, but since we are unsure when it will commence, our best option is to carry on with our investment decisions normally and ride out the natural business cycle.
Even if we are quite certain we will face contraction within the next year or so, we can hedge risk by implementing a defensive asset strategy. This involves shifting portfolios towards stocks with lower betas so that overall market risk associated with the portfolio decreases. Investors will take a lower expected return, but portfolios will still be able to make returns during down years. Holding more debt securities is another option as it reduces equity exposure to create a less volatile portfolio. Either of these scenarios are superior to withdrawing funds from the market and they will benefit both the investor and the economy as a whole.
On the positive side, many professionals in the finance industry still hold a positive outlook, with Goldman Sachs declaring recession risks to remain relatively low and forecasting “low but positive returns”. They believe that a more extreme, prolonged inversion would be necessary to cause real concern. Calm sentiments are vital to the finance industry’s operations though, so public announcements should be taken with a grain of salt. Nothing is certain at this point and investors should expect the current trend of market volatility to continue throughout the near future.