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April
05
2019

Why An Inverted Yield Curve Is Important
Erik Conley

Summary

The yield curve recently inverted, and market pundits are running around like their hair is on fire.

In this article, I'll offer some possible explanations for this upside-down interest rate environment.

On average, it only takes 8 months for the market to top out after an inversion, and this is the big takeaway for investors.

This idea was discussed in more depth with members of my private investing community,The ZenInvestor Top 7.

An inverted yield curve happens when short-term interest rates become higher than long-term rates. For this article, I will use the 10-year Treasury note for the long-term rate and the Fed Funds rate for the short term.

The yield curve recently inverted, and market pundits are running around like their hair is on fire. Why is this getting so much financial media attention, and causing alarm among the investment cognoscenti?

One reason is that a curve inversion is an unnatural state for an economy to be in. Why would an investor buy a 10-yr bond when she could get a higher interest rate with a 30-day T-Bill? It makes no sense from a practical standpoint. Is the short-term rate too high, or is the long-term rate too low? We will address this later.

Curve inversions may be unnatural, but they happen, and it's happening now. Later in this article I'll offer some possible explanations for this upside-down interest rate environment, but first let's go through the inversion events that have happened in the past. By doing so we can gain some insight about what an inversion means to investors in stocks and bonds.

The Big Picture

The first chart comes from JPMorgan Asset Management. It shows the yield curve and the recessions that followed. This chart shows that when the curve inverts, a recession is very likely to follow several months later. I don't know of any economists who dispute this assertion because history is history and not theory.

It's important to note that there is a significant lag between the first inversion date and the onset of the recession. The average lag time is 14 months, which means that there is no need to panic right now. There will be sufficient time to get your house in order before the next recession comes to town.

 

Trader & portfolio manager, from 1975 - 2001. Former head of equity trading at Northern Trust Co. in Chicago. Now a private investor, founder of a nonprofit investor advocacy firm, and private investing coach. It gives me great satisfaction to teach small investors the same skills and strategies that I used with my high net worth clients as a private wealth manager. It may be a cliche, but giving something back to the community is more rewarding to me than helping very rich people get even richer.

 

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