What’s a Yield Curve?
The hot topic this week is the yield curve, or more importantly, the inverted yield curve. What the heck is a yield curve? It’s a collection of interest rates, or yields, plotted on a chart. Rates begin with the one-month U.S. Treasury Bill and end at the 30-year U.S. Treasury Bond. The curve plots all points in between.
Historically, it slopes upward and to the right because short-term rates have been lower than long-term rates. Makes sense. If you buy a 30-year bond, you want to be compensated for your risk in the form of a higher rate.
The yield curve can be normal, flat or inverted. The chart below shows all three. Blue is normal, orange is flat, and gray is inverted.
A normal yield curve tells us that if we buy a long-term bond, we’re going to earn more interest than a short-term one. With a flat yield curve, it doesn’t matter which bond you buy, because all rates are the same. When the yield curve is inverted, you earn more interest with a short-term bond than you do from a longer term one.
A normal yield curve also signals a strong economy with no known issues on the horizon – ceiling and visibility unlimited. When the curve inverts, trouble awaits. What trouble? A recession. An inverted yield curve has previously been a reliable recession indicator. It’s a sign our economy may be losing steam.
It’s true, an inverted yield curve has been a good indicator. However, the correlation between an inverted yield curve and a recession is not instantaneous. It may take one to two years before a recession occurs after the curve has inverted. It takes time to slow down a $20 trillion economy.
Is the yield curve currently inverted? No. The yield on the one-month T-Bill is 2.334% while the rate for the 30-year T-Bond is 3.176%. This is a normal yield curve, sloping upward and to the right.
Parts of the yield curve are inverted. The 2-year and 5-year rates are slightly inverted. Experts are concerned that this is the beginning of the end, but this is like a driver in Houston who’s worried about a traffic jam in Los Angeles.
The Fed Funds rate is currently yielding 2%, the only rate the Federal Reserve controls. The remaining rates are left to market participants – buyers and sellers. If we compare the Fed Funds rate to all interest rates, the yield curve is normal.
Earlier this year the market sold off because interest rates were rising. Today stocks are selling off because interest rates are falling. The recent price action in the stock and bond markets can be attributed, mostly, to the uncertainty surrounding the trade war between the U.S. and China. Markets hate uncertainty. When investors stare into the abyss of the unknown, they sell stocks and buy bonds. When bonds are bought, rates fall.
The price of oil has also dropped. Lower oil prices coupled with lower rates are a positive for the consumer. The current unemployment rate is 3.7%, so 96.3% of Americans are working. When the American worker pays less at the pump and takes advantage of lower interest rates, they spend money – a boost to our economy.
In the movie Top Gun, Maverick and Goose inverted their F-14 Tomcat, so they could take a picture, and give the bird, to a Russian MIG pilot. After the encounter, they return the plane to normal, fly back to Miramar and buzz the tower. Their inversion didn’t hinder their ability to continue to fly the plane.
Slower growth doesn’t mean no growth. If our economy was travelling at 75 miles per hour a couple of years ago, it may be cruising at 55 MPH today.
Our economy is strong, corporate earnings are robust, interest rates are low, and taxes are favorable. These factors bode well for a higher stock market at some point. Follow your plan, diversify your assets, think generationally, and good things can happen.
Because I was inverted. ~ Maverick, Top Gun
December 7, 2018
Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process to help our clients pursue a life of purpose.
Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.