Inverted Yield Curve, What Does it Really Mean?

APA Jones 3x4HI RGBAnother important section of the yield curve inverted this month. News of such sent stock markets into a frizzy. Market volatility, both to the downside and upside, signifies investors are trying to determine what this inverted yield curve really means. So, what does it really mean? 

The yield curve is a good indicator of potential growth over different periods of time. With a normal upward sloping yield curve, expectations are for spending and borrowing activity to start increasing, which requires lenders to charge a higher interest rate to borrow for ten years than for two years. This makes sense. The longer someone borrows money, the higher the risk to the lender and the more inflation can eat into the principal. 

However, an inverted yield curve tells a different story. With an inverted yield curve, lenders are willing to lend money fora longer period of time because they do not expect spending and borrowing to increase, or inflation to rise, and therefore they would prefer to lock in an interest rate for a longer period of time. Essentially, the current inverted yield curve is telling us expectations for growth in the near-term are higher than expectations going out a little further. 

Here lies the key. An inverted yield curve does not in itself cause a recession. However, it signifies a weak economic environment that is at higher risk of a recession. In other words, the economy is on the edge, and all it would take is some shock to the system for the economy to go over the edge into recession. What could that shock look like this time? 

While every recession is different, most occur because of a slowdown in consumer confidence and consumer spending. After all, the consumer accounts for nearly 70% of the U.S. economy. To date, the consumer is feeling very strong as evidenced by the latest GDP report, consumer confidence readings, and retails sales reports. Surprisingly strong, actually, considering all the negative headlines floating around. Consumption strength has offset the slowdown in business investment and negative impacts from trade. However, a slowdown in consumer spending could easily be that shock to send the economy over the cliff. 

It’s important to understand that an inverted yield curve does not signify imminent doom and gloom. In fact, it can take six months to two years after inversion for a recession to hit. In the meantime, stock markets can actually perform well for much of that timeframe. However, risks are increasing, and it is more important to gauge new data looking for changes to the current path.

AllegiantPA Economic Dashboard Portrait September 2019Allegiant’s Economic Dashboard was designed specifically for times like this. Risks of a recession are increasing, as is fear over the possible outcomes. However, the Dashboard shows that the economy is definitely not past the point of no return. In fact, the Dashboard only shows one red indicator and two yellow indicators. We are looking for three red indicators before risks of recession may be too high to overcome. One or two good pieces of news could return the economy back to solid ground. 

One thing is for sure, it would be very hard for the Federal Reserve to stand by, watching an inverted yield curve, and do nothing. Which means, more interest rate cuts could be on the horizon, unless the yield curve steepens over the coming weeks. As this unfolds, we will look for the economy to respond positively. If not, we will be prepared for increased risks over the coming years. 

If you would like to see more data and charts about the economy and various financial markets, please click below to view or download our Monthly Insights book.

Benjamin W. Jones, CFP®, AIF®
CERTIFIED FINANCIAL PLANNER™
President, Chief Investment Officer, Principal