Inverted Yield Curve: Stock Market Crash Predictor?
What’s an inverted yield curve?
What’s a yield curve, period?
As you may or may not know, I have a background in finance. Most of what I do isn’t that useful with regard to personal finance. I invest in complicated investments reserved exclusively for giant institutions and obscenely wealthy individuals.
However, whenever I get the chance to tell you, my fine reader, about something that pops up onto my radar that is also relevant to you, I immediately write a post about it.
Since I check in on the 10-year Treasury yields regularly (they’re part of the IHR), I notice when things get squirrely.
The topic of today’s post is yield curves.
More specifically, inverted yield curves.
Doesn’t sound nice, right?
An inverted yield curve is BAAAAAAAD news.
The inverted yield curve is one of the most, if not the most, reliable predictors of a stock market crash around.
To learn what an inverted yield curve is, how/why it’s such a reliable predictor of stock market crashes and economic recessions, and how it affects your finances, continue reading. I promise you it’s worth it.
Before we dive into yield curves, we have to understand bonds.
A bond is a loan, but instead of you getting the loan, you’re the one lending the money.
A bond is issued by private companies and governments (federal, state, municipal). Unlike a personal loan, however, bonds only pay you interest. There is no paydown of principal like you see on a mortgage.
So if you buy a five-year bond for $100 and it has a 5% yield, that company will pay you $5 annually for five years and then return your original $100, or principal. Your annual $5 yield is your prize for trusting the company with your money. You could have invested that money in something else, so the bond issuer enticed you by offering a guaranteed annual yield (you hope).
The government also issues bonds, but those are called Treasuries. U.S. Treasuries are considered as risk-free as it gets, hypothetically. However, this does not prevent market forces from impacting the price of these “risk-free” instruments.
Interesting Characteristics of Bonds
The longer you have to wait to get your original $100 (principal) back, the higher the yield you’ll typically get. Longer duration bonds yield more, all else being equal.
You can also calculate your exact return on investment (ROI) the second you buy a bond, which is unlike almost any other investment. This return is guaranteed. You will get this return unless the company (or country) that issues it goes bankrupt.
Your ROI will also change if you decide to sell this bond on the market before it reaches maturity (expires after five years, for example), but that’s beyond the scope of this post.
Yield Curves: The Good, the Bad, and the Fugly
What It Is
When people in finance talk about “yield curves,” what they’re typically referring to is the delta/difference/spread between the rates of two different debt instruments. The usual suspects here are the Treasuries; the 2 and 10-year treasuries.
Yield curves are usually measured in basis points, bps or “bips.” So instead of saying 1%, you say 100 bips. Nothing crazy, right?
Typically, 2-year Treasuries have a lower yield (annual cash payout) than 10-year Treasuries.
Why? There’s less that’s likely to go wrong in a two-year timespan than a ten-year timespan. You get compensated for taking on additional risk for longer (the 10-year Treasury) by getting a higher yield. That difference between rates is one point on the yield curve.
Ok, so now that we’ve established what a yield curve is, let me show you some examples of them.
Normal Yield Curve (The Good)
“Normal.” Sounds nice, right? Nice and safe. Normal yield curves show up to work 15 minutes early with their sweater vests in impeccable order.
A normal yield curve depicts the dynamic I covered above: 10-year Treasuries have a much higher yield than 2-year Treasuries.
This is what a normal yield curve looks like when graphed:
The graph above depicts this: as the maturity of the Treasury bonds increases (i.e., they’ll pay you back the principal you invested on Day 1 in 2, 5, 10 years), the amount of money they yield annually goes up.
There are echoes of this in personal finance as well. All else being equal, and under normal conditions, your interest rate on a 15-year mortgage is less than the interest rate on a 30-year mortgage. You’re paying the bank more for a 30-year mortgage because the likelihood of you not paying that mortgage increases along with its duration. Divorce, death, unemployment, or absconding with the pool boy and leaving your Aunt Maria with the bills are all more probable with a longer time horizon.
Flat Yield Curve (The Bad)
Ok, now things are starting to look weird. Flat yield curves show up to work late repeatedly, and you think you may have caught a whiff of whiskey.
With a flat yield curve, you get paid the same yield for holding a 2-year Treasury and a 10-year Treasury!
What?!? Why does this happen, it defies sense!
It’s great if you’re only interested in the shorter duration Treasuries, but if you want more extended duration 10-year or 30-year Treasuries, you should be getting paid more!
We often see the yield curve flatten when the Federal Reserve starts aggressively increasing interest rates.
The yield curve has gotten flatter recently. Check this out:
As the graph shows, the yield curve is now as flat as it was in 2007.
Now, on to the belle of this horrendous ball.
Inverted Yield Curve (The Fugly)
Be afraid. Very afraid.
I’m about to show you something hideous and unnatural.
This curve is demonic. It means that you get paid less for taking on more risk. It upsets the natural order of things. The inverted yield curve stole a company car, ran up a lot of highly questionable charges in Las Vegas, and replies-all to e-mails from the CEO with “LOL.”
In this scenario, the 2-year Treasuries yield more than the 10-year Treasuries. Why? Investors are less confident that they’ll get paid back and therefore less likely to buy longer duration bonds.
Inverted Yield Curve = Stock Market Crash and Recession?
The inverted yield curve has accurately predicted seven of seven recessions in the last 50 years. If you know of anybody or anything with a better track record as a prognosticator, tell me, please.
How Does an Inverted Yield Curve Affect Me?
If you’re invested in longer-term bonds, you’re going to see the yields dip. This is significant if you rely on bond-income in retirement in any way.
If you have an adjustable rate mortgage (“ARM”) on your home, it’s highly likely that your interest rate is pegged to short-term rates. This means your interest rate will go up drastically and painfully when your rate resets.
If you’ve retired on the back of a dividend-paying stock portfolio, you can expect your dividend stock prices to lag as rates increase. In short, it’s because that relatively high 3 or 4% dividend yield is now equal to or less than a “guaranteed” U.S. Treasury. This diminishes its relative attractiveness. Dividend stocks will likely be discounted, so you can scoop some up!
Additionally, as a saver, you stand a chance of making a decent return on your savings account. It’s not all bad, eh?
What Can You Do About an Inverted Yield Curve?
In as few words as possible, not much.
Make sure you don’t have any adjustable interest rate debt! If you have one of those ARM mortgages, get a fixed-rate one if you’re worried about the inverted yield curve. In this scenario, your interest rates will explode upward with an ARM.
Additionally, make sure you don’t carry any credit card debt. Credit cards are the “revolving line of credit” for us the hoi polloi, and unless you want to get walloped with even higher interest rates, pay them off ASAP.
If you own a business with an actual adjustable-rate line of credit (I’ve never heard of a fixed-rate LOC), pay it off or find better sources of financing.
Other than that, ride out the storm and get ready to buy-up some wonderful assets when they’re heavily discounted.
I hope you’ve enjoyed learning about the inverted yield curve today. While it’s not as fun as almost anything else you can do on the internet, you now have valuable knowledge.
If you become a subscriber, you’ll get the occasional and never-scheduled MSoLife Mooseletter. I write it when I feel like it and when I’ve got enough to talk about. This newsletter is never forced, ever. I never spam, and you can unsubscribe whenever you want to.
In the Mooseletter, I talk about the economy, useful Stoic quotes and ideas I run across, cool DIY projects, and dive into more in-depth detail on certain financial topics. I’ll also send you advanced copies of any e-books, guides, and courses I put out to get your feedback, well in advance of when I publicize them on MSoLife.
But wait, there’s more…I’ll also send out a heads-up to all my subscribers if/when the yield curve entirely flattens and if/when it inverts! You don’t need to constantly Google these charts. I’ve got your back!