Will an inverted yield curve turn your investment world upside down?

Will an inverted yield curve turn your investment world upside down?

Let's start with the basics so we're all on the same page. When most people discuss the yield curve, they are talking about interest rates for US Treasuries across different maturity dates.

Short term rates stay close to the federal funds rate set by the Federal Open Market Committee. When the Fed is concerned about inflation or an overheating economy, they raise rates. When inflation is low or they fear a recession, they reduce the rate.

Long-term treasury rates are determined by demand in the bond market. In good economic times people demand a high interest rate to forgo investments that offer higher returns. In tough times they'll take any port in a storm and accept lower interest rates for safety.

Generally, you get paid more interest for longer maturities because there is more risk over 30 years than over 30 days. However, that isn't always the case. If market participants and the Fed don't have the same outlook, you can have long term rates that are below short-term rates. This is called an inverted yield curve and is often viewed as a precursor to recession.

Historically inverted yield curves signal a slowing economy or even recession. Short term interest rates are putting the breaks on growth. At the same time long term investors are expecting lower returns. That means investors are pessimistic. It would be nice to believe that investment professionals are data driven and logical but human emotions in the form of expectations are often a dominant market force.

Currently the market is solidly in pessimistic territory. As of the time I write this the 3-month Treasury is yielding 2.34% while the 10-year Treasure is at 2.11%. That tells you the bond market is predicting little growth or inflation. Are the bond investors accurately predicting a slowing economy or is their pessimism creating it? It doesn't matter.

Personally, the idea of accepting a 10-year annual return of 2.11% is crazy. However, this is a time to be cautious. Steel yourself for a potential market drop and make sure you're prepared to buy in. In the short-term pessimism could rule the day. In the long run optimism has always prevailed.

If you like the idea of making money in the long run but dread the idea of market declines give me a call. You might like how I manage risk because it's easy to understand and instills confidence.