By CCN Markets: On Wednesday, the bond market once again experienced an inverted yield curve. The behavior in the bond markets has been interesting as of late, and another instance of this yield curve inversion demands that we take a closer look at what’s going on.
First, let’s review what an inverted yield curve implies.
Normally, short-term bonds pay less interest than long-term bonds. That’s because the economic situation for two-year Treasury note is less likely to change in the short term of two-years than it will over a longer term of 10-years. Therefore, it carries less economic risk.
It stands to reason that interest rates on the two-year Treasury note will generally be yielding less interest than that of the 10-year Treasury note.
From time to time, however, we see a weird thing happen. Interest rates on the 10-year bond yield are less than interest rates on the two-year bond.
Why does that happen?
Declining interest rates indicate a possible recession.
Interest rates decline during this period because the Federal Reserve wants to encourage people to borrow money to invest into the economy, so it lowers interest rates to encourage this behavior.
Except people who are seeking regular fixed income don’t like having interest rates decline.
So they shift into buying longer-term bonds, such as the 10-year Treasury note. Interest rates are negatively correlated to price. So as demand for the 10-year bonds rise as people buy more and more of those bonds, the 10-year interest rate declines.
An inverted yield curve occurs when the interest rate on that 10-year note is less than the interest rate on the two-year note.
Ed Butowsky, Managing Partner of Chapwood Capital Investment Management, tells CCN:
“While an inverted yield curve has traditionally been a signal for coming recession, that’s not always the case. It depends on a number of other factors, including how long the curve remains inverted. What we’ve actually seen over the past few days is the yield curve inverted, then returned to normal, and has inverted again.”
That tells us that sentiment amongst investors is not heavily stacked in one direction or another.
There appears to be a good deal of uncertainty regarding the prospect of a recession.
I would expect to see these yield inversions occur several more times before finally settling in for a lengthy period of time.
Still, we have to remember that there are other factors at play.
For example, if the United States suddenly achieves a trade war settlement with China, or if Congress institutes a payroll tax cut, or some other fabulous economic news repeatedly hits the wires, sentiment may suddenly turn around.
That’s why it’s so important to simply have a long-term diversified portfolio.
That removes any concern on your part regarding crashes, recessions, inflation or anything else. All that matters is that you have a long-term time horizon, which blunts the effects of any given circumstance.