Ah, the end of summer—and the beginning of the chaos that back-to-school brings. We dropped our oldest, Maeve, off to college for the first time, and the twins embark on their second year of high school. Our household seems to have been turned upside-down. Add in the stress of Phoebe and Sophie getting their driver’s licenses, and our relaxing summer is quickly becoming a memory already!
Very few of us really enjoy living in a state of disarray. When life throws us a curveball, we believe that our best bet is to face the challenge head-on and make the changes necessary to right ourselves. In our household, that sometimes means just knowing that life will be a bit crazy for a while and preparing ourselves to handle whatever comes our way. We need to be ready for it, and accept that we’ll be OK if we can just ride out the storm.
Speaking of being turned upside-down, our friends on Wall Street recently sent a message that it thinks a financial storm may be coming. I’m talking about the recent chaos that ensued when the yield curve inverted....Again.
Inverted yield curves have made news a few times this past year. I find that there is a lot of confusion about what the inverted yield curve is and what it means to investors, so let’s dig right in.
First of all, a quick recount of what has happened so far: Put simply, fears of an economic downturn triggered a selloff in the stock market. More specifically, investors got spooked following news that the yield on 10-year treasury notes temporarily fell below the yield on two-year treasury notes. It’s the first time it’s happened since 2007.
And we all remember what happened in 2008.
You see, bond investors examine the interest rates, or yields, of treasury bills as a yield curve is a plotted line on an X-Y graph. The X-axis of the chart, or the horizontal part, represents the length of time it takes that bond to mature. The Y-axis—the vertical component of the graph—is the interest rate, or yield, paid to investors.
Yield curves can be created to plot the activity of a wide variety of bond categories. The yield curve that’s so often in the news is specifically the curve of US Treasury securities. The US Treasury sells bills, notes, and bonds in 12 different maturities—one-, two-, three- and six-month bills; one-, two-, three-, five- and 10-year treasury notes; and 30-year bonds.
When the economy is moving upward, and inflation stays under control, that yield curve will typically slope upward, starting from the short-term maturities on the left to the long-term ones on the right. Short-term bonds usually offer investors lower yields because the risk to investors is more moderate.
Longer-term bonds pay investors more because their risk is more significant. Capital is tied up longer, and future inflation may erode the investment’s real return. That only makes sense, right? You should generally expect to get a higher interest rate if you’re locking up your money for a longer time.
When the yield curve inverts, as it did in August, shorter-term interest rates become higher than longer-term rates. Cautious investors tend to seek shelter in longer-term bonds, driving down their yields. The surge in demand for those bonds has driven their yields down to historic lows: The yield for 30-year bonds dropped below 2 percent for the first time ever during the August event.
Investors will often turn to longer-term treasury bonds when they believe that economic growth may slow, or if they fear that the markets will become more volatile. The surge in demand causes yields on long-term bonds to drop.
This isn’t the first inverted yield curve we’ve seen in the past year. It happened with other treasury bonds last December when the yields on two- and five-year notes inverted. Ten-year notes also fell below the yield for the three-month T-bill in March.
Inverted yield curves may be harbingers of recessions, according to a 2008 paper published by Glenn Rudebusch and John Williams of the Federal Reserve Bank of San Francisco. They correlated inverted yield curves in 1989, 2001, and 2006 to recessions that occurred in 1990, 2001, and 2008.
Research correlating inverted yield curves to recessions suggests that inversions may proceed a recession by some time—a year or more in most cases. So an inverted yield curve is not necessarily a cause for panic...today. What’s more, inverted yield curves can and have happened during periods of economic stability. But trouble in the bond market is not an encouraging bellwether for investor confidence. We have yet to see how the Fed will address this going forward, as of this writing.
The inverted yield curve news set in motion the worst session the Dow has posted since 2019 began. And that sort of activity certainly suggests you should be aware and cautious right now.
Folks, that’s why it’s critical, today, to look carefully at your investment system to determine if there are any gaps. Defining your gaps and implementing a Gap Mitigation Plan (GMP) now, before a recession, is tantamount to financial success.
So, what is your risk budget? Is it defined and quantified? How did your system behave in the last quarter of 2018 when the markets collapsed over 20 percent? How did it fare in 2008, after the last yield curve inversion? Did you just buy and hold through it all? Why?
Now is a great time to define your gaps, understand what they mean and the potential impact if you don’t implement your Gap Mitigation Plan. It may be the best solution to help you protect your investments when the market changes. And they will change fast.
A proactive investment system should employ risk-mitigation triggers, incorporates a defined and quantified risk budget based upon your specific tolerance, and is built upon a philosophy that if you manage the downside first, the upside should take care of itself. Such triggers, based on quantitative data (such as the inverted yield curve), may help folks achieve a greater probability of financial success by preserving and protecting investments when things get messy.
Summer on Cape Cod is winding down, and we still have some beautiful weekends left before the weather turns cold and gray. But when life gets a little crazy, you can take steps to help you more comfortably ride out the storm—after all, only the most foolhardy among us blithely go on as if nothing is happening. In the same way, understanding your gaps and implementing processes to help manage your investment system’s downside risk may help to put you in a higher probability for financial success.
What are your gaps? Do you know? Should you?
Hmmm... now is a good time to be vigilant and to stay alert, because you deserve more.
Have a great week!