If you pay much attention to financial news, you may have noticed some recent dramatic headlines warning of an upcoming recession. What triggered the warnings was something called the “inverted yield curve.”
To explain that term, it helps to understand bond markets. When you invest in bonds, you are essentially loaning money to the bond issuer. You will receive a higher interest rate on long-term bonds than on short-term ones. This makes sense, since the long-term bonds tie up your funds for a longer period of time.
The yield curve is a line on a graph that shows the interest rates on bonds of various term lengths, from three months to 30 years. When the short-term bonds offer higher yields than the long-term ones, this is a yield curve inversion. Based on trends over the past fifty or so decades, an inverted yield curve is considered to indicate that a recession is on its way. There has been such an inversion before each of the last seven recessions.
As a warning signal, however, an inverted yield curve isn’t all that reliable.
For one thing, two different historic inversions—one in 1966 and one in 1998—were not followed by recessions. The one in 1998 was largely flat. Similarly, the current inversion was slight. The interest rate on a three-month Treasury note was higher than that on a ten-year bond, but only by 0.022%.
In addition, there’s no way to predict the timing of a recession based on an inverted yield curve. Previous ones have occurred at widely varying times, meaning there is no way to create reliable investment strategies in response.
Another important factor to keep in mind is that, as pointed out by Simon Moore in Forbes, an inverted yield curve “implies a 25% – 30% probability of a recession on a 12-month view.” This is hardly a high-odds prediction of an imminent threat. It means there is still roughly twice the likelihood of no recession within the next year as there is of a recession occurring in that time.
In addition, we’re not currently experiencing several other conditions that can signal an approaching recession. These are rapid GDP growth, rising unemployment, and spikes in interest rates. We’re still in a long period of slow growth, unemployment remains low, and the Federal Reserve recently announced it was not raising interest rates. The announcement also indicated rates are unlikely to increase over the coming year.
Does all of this mean you should assume we’re not going to see a recession any time soon? Not necessarily. One thing we can assume is that the next recession will come. We just don’t have any way to accurately predict when it might show up.
Rather than worrying about such predictions, investors can choose to focus on maintaining diversified portfolios and taking the long-term views. Ironically, one scenario that might make a recession more likely is a large number of investors reacting with fear to headlines that predict one. When people change their investing and spending behavior in anticipation of a recession, they increase the probability of one occurring sooner rather than later.
According to Simon Moore, “. . . the markets are capable of learning too, and there is some evidence that recessions are self-fulfilling, meaning that if enough decision makers expect a recession they may then take the very actions, such as temporarily cutting back on spending, that cause a recession to happen.”
As always, it is a good idea for ordinary investors not to pay too much attention when economists, investment analysts, and other number-crunching gurus get excited about portents and predictions.