BAirwaves don’t usually get as much attention as stocks. But now that a key bond market indicator is signaling a possible recession, bonds are in the headlines.
Indeed, the yield curve, an indicator used by analysts to gauge the economic outlook, is starting to look wobbly. The yield curve is a graph of bond yields—typically, the yields of US government-issued Treasury bills—that plots the time horizon on the x-axis and the yields on the y-axis.
Bonds with longer maturities, such as the 10-year US Treasury, tend to have higher yields than those with shorter maturities, such as the 3-month US Treasury. It makes sense: if you’re willing to lend your money to the government for a longer period of time, you can expect to be paid more.
Yet, at the end of March, the 2-year Treasury yield was trading above the 10-year yield for the first time since 2019, marking what is called a “reversal in yields”. The yield curve inverted again last week. The last six times this part of the yield curve inverted, a recession followed 18 months later on average, according to LPL Financial.
Here is what you need to know about this bond market indicator.
What is a yield curve inversion?
Bonds are debt securities issued by a company or government, and generally the longer you are willing to lend your money, the more you will compensate for lending that money. Therefore, when the yield curve is “normal”, a security with a longer maturity, such as a 30-year bond, will offer a higher interest rate than a 10-year bond.
But when long-term yields fall below short-term yields, the yield curve inverts. This inversion tends to reflect investor uncertainty about the future of the economy.
What does an inverted yield curve mean for the economy?
Certain parts of the yield curve carry more weight for analysts than others. Historically, when 3-month treasury yields are higher than 10-year bond yields, there’s been a recession for the next two years, says Kathy Jones, chief fixed-income strategist at the Schwab Center. for Financial Research.
Experts also tend to watch 2-10-year rates, which have reversed in recent weeks.
“The reversal in the curve should signal that a downturn is ahead,” Jones says. But of course it’s not a lock, a recession is imminent. “It’s not a precise science.”
It is now up to the Federal Reserve to decide how aggressively it will raise interest rates to curb inflation, a practice known as tightening. The Fed recently announced its intention to raise its benchmark rate by a quarter of a percentage point, bringing it back to the range of 0.25% to 0.5% after keeping rates near zero since the start of the crisis. pandemic. Fed Chairman Jerome Powell also said the Fed stands ready to raise rates even more aggressively, if deemed necessary, to fight inflation.
“Tightening tends to go a bit too far and tip the economy into a recession,” adds Jones. Rising interest rates make it more expensive for consumers and businesses to borrow money, which generally reduces demand for goods and services and cools the economy. But if inflation and energy prices fall, for example, the Fed could slow the pace of rate hikes because it wouldn’t feel as much urgency, Jones says.
How did we come here?
After the COVID-19 crisis devastated the economy in 2020, the country started to recover last year much faster than initially expected, as evidenced by soaring inflation.
Then, in late 2021, Powell indicated that the Fed thought it should start raising rates, which started the process of sending higher yields as the market priced in stronger growth and more inflation. says Jones.
In addition, the war in Ukraine has further increased prices, especially energy costs. The Fed, in turn, must react even more strongly.
“The Fed has gone from worrying about jobs, the economy and disinflation to trying to get ahead of inflation,” said Matt Eagan, portfolio manager and co-head of the total discretion team at Loomis Sayles. “They were terribly behind on that curve, so now they’re catching up.”
Should investors prepare for a recession?
As Jones says, a reversal in yields doesn’t mean we should immediately buckle up and prepare for a recession. But it signals likely distress to come.
“We don’t think recession is in the cards for this year,” said Lawrence Gillum, fixed income strategist at LPL Financial, in a recent blog post. “If the Fed follows through with the expected rate hikes – a big if – we are likely to see the 3-month/10-year close to reversal by the end of the year, which would likely mean that the recession could be a 2023/ event 2024.”
As UBS Chief Investment Officer Mark Haefele pointed out in a recent note to clients, there is often a long lag between reversals and recessions. Of the last 10 times the U.S. curve inverted, there were three times when there was no recession for the next two years. Moreover, the timing is uncertain. On average, rethe divestitures began 21 months after a reversal, but they lasted from nine to 34 months, Haefele added.
Moreover, the 3-month/10-year yield curve is not inverted for the moment. It is only when a majority of points on the yield curve invert that a recession over the next two years becomes “increasingly inevitable,” Bespoke Investment Group wrote in a recent note to clients.
What does this mean for your portfolio?
The usual investment advice still applies: the best strategy is to have a solid investment plan with a diversified portfolio in place and stick to it, even when you’re scared.
Financial experts recommend having a mix of stocks, bonds and cash, with an allocation to each based on your financial situation, goals and risk tolerance. For example, Rob Williams, managing director of financial planning, retirement income and wealth management at Charles Schwab, recently told Money that for the average person with an investment horizon of 10 years or more, a 80% allocation to stocks and equity funds (both American and international) is the most likely route to wealth.
But if you want to take action now, you can reduce your portfolio’s risk a bit, Jones says. This doesn’t mean selling all of your stocks or bonds, but perhaps withdrawing money from more speculative investments, like cryptocurrency. When excess money flows through the markets, it tends to go into speculative assets, but they are also the first to underperform when that liquidity exits.
Fixed-income investors may also want to start locking in mid- to long-term yields, as yields are likely to be lower by the time the Fed completes the process of raising rates, Jones says.
“We actually think this is an opportunity for income investors to add some exposure,” she adds.
If you hold cash on the sidelines but a 2-year Treasury is going to pay you 2.5%, why not consider the latter? Investment-grade corporate bonds are an area of opportunity for investors right now, Jones adds. You can find information on various corporate bond funds through Morningstar.
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