Is the Inverted Yield Curve Reason to Worry?

If you’ve been paying attention to investment news, you might be aware of the recent consternation that the “yield curve” in financial bond markets has “inverted.” (If you’re not, or aren’t entirely sure what this means, read on.) For some, the takeaway from this is immediate: if you believe in the ability of sporadic market information to portend coming recessions, history does suggest that an inverted yield curve precedes them, so there’s reason to be concerned when observing an indicator like this.

But in order to make sensible, informed decisions as investors and financial planners, we need to take a closer look before drawing any conclusions. So, what exactly does it mean when the Yield Curve “inverts” – and is it something that you should worry about?

The Yield Curve: An Investment Definition

The yield curve is a basic XY chart that plots the yield (how much income you receive as a percentage of the value) of similar credit bonds vs. their term (how long before the bond matures). It shows what an investor can expect to receive in interest payments for bonds of varying terms. A “normal” yield curve shows what you’d expect: longer-term bonds have higher yields (they are usually considered riskier, which in a stable market should translate to higher interest payments), and short-term bonds yield less.

*Hypothetical illustration. Does not represent any specific time frame or data points.

What Does an Inverted Yield Curve Mean for Investors?

When the yield curve inverts, it means that short-term bonds are paying higher yields than long-term bonds – the reverse of what you’d expect. Put another way, it means that investors see more risk in the short term than in the long term, which is generally not a good sign for the economy.

Can an Inverted Yield Curve Predict Recession?

Since 1970, a yield curve inversion has been observed before each US recession. Many market commentators and investors consider this to be confirmation that an inverted yield curve automatically “predicts” a coming recession, and thus gives us valuable information that should inform our investment decisions.

This isn’t entirely baseless. The reason one might believe an inversion in the yield curve “predicts” a recession is that it usually happens a year or two before a recession; at least, it has during the past 50 years. But that’s still a relatively wide window, and makes it hard to base any concrete, time-bound investment decisions on what amounts to more of a suggestion or strong hint than a trustworthy prediction. And even then, only a specific type of inversion happens before a recession, the sporadic nature of inversions lends a small sample size, and the relatively short historical time frame used as a measuring stick doesn’t inspire much statistical confidence.

So, given all this, can we rely on an inversion to predict the next bear market?

Should an Inverted Yield Curve Affect Your Investment Decisions?

Ultimately, predictions – even valid ones – are only as useful as their specifics. After all, scientific evidence suggests there may well be a major earthquake or other natural disaster somewhere “soon” (in historical terms, at least) here in the Pacific Northwest – but does that mean we should all quit our jobs and start preparing for the end times? Not just yet, at least not until we get some better information.

Personally, I’m highly confident there will eventually be another bear market after this yield curve inversion. Am I correct? Probably: bear markets occur every 3 or 4 years on average, so my odds are pretty good, yield curve inversion or not. But is that actionable information? No, because without a specific timeframe, it’s essentially useless.

Timing Is Everything

Market decisions need to be based on more than just the possibility of a trend, even if it’s very likely, because timing makes all the difference in how you might stand to benefit or lose from acting on it. Mistiming a market correction, even by only a few months, can cost you more return than you would have saved if you had chosen to stay the course and kept your money invested.

So, to put it bluntly: yes, of course, there’s going to be another recession at some point. Yes, of course, there will be more bear markets in the future, sooner or later. But that is to be expected even when the yield curve doesn’t invert: that’s simply the reality of being a long-term investor. What’s important is not knowing that these trends might or even will occur, because they always will eventually – but instead, how to give yourself the best chance of success for your specific goals.