August 19, 2019
If you’ve been following financial news lately or religiously tracking your net worth on Mint like I do, you probably noticed last week’s hiccup in the market’s relentless march upwards. The Dow dropped 800 points in a single day — the worst performance of 2019 (so far).
Financial news media was all over this story. I woke up to dozens of articles about the 2/10 inverted yield curve and pictures of grown men sobbing in front of their computer screens gracing Yahoo Finance. I felt like we traveled back in time and Lehman Brothers just collapsed.
Naturally, the first thing I did was to Google “what is an inverted yield curve?”.
Despite it’s sophisticated name, it is a relatively intuitive concept to understand. Let’s break it down.
Our government occasionally spends our tax money irresponsibly and has a shortfall between its obligations and the cash it has on hand*. To make up the difference, the government sells treasury notes (T-notes for short) to investors that are looking for a safe place to keep their money.
All notes have a maturity date — the date the investor can expect to have their money back, and an interest rate — an incentive for the investor to lend money in the first place.
That incentive is also the “yield” in “inverted yield curve”.
The maturity date can vary between two and ten years. In general, lending money for shorter duration is less risky. There is less opportunity for your borrower to become a deadbeat and there is less risk for the interest rates to shift dramatically. Therefore; investors in general expect higher return from longer term investments.
That’s the “curve” in “inverted yield curve”.
Finally, what happens if investors become pessimistic about the future? First, they will start demanding higher interest rates to lend money in the short term driving 2 year T-notes’ interest rates up. Second, they will flee with their money for safety buying up long term T-notes and in turn driving those interest rates down. If this continues for long enough, the 2 year T-note can exceed the 10 year — creating an a-typical inversion. Thus; we have the “inverted yield curve”.
We’ve witnessed inverted yield curves before in 1980, 1989, 2000, and 2006 — all years that preceded a recession by a year or two.
The discerning reader may have also noticed the gray bars in the chart above. Those signify economic recessions in the United States. As of this writing, we haven’t had a recession since 2009 — a full decade and longest bull market in history. Things aren’t looking good.
Before you speed dial your broker and put in that sell all order, let me offer some advice.
First, though 800 points drop for the Dow sounds like a lot, it is roughly 3%. It happens over a two or three day span all the time and no one really notices. Don’t let that part scare you.
Second, the inversions, even if truly predictive, occur one to two years prior to the recession. Therefore; you should wait until August 2020 before selling anything at the very earliest — at least if you believe in these indicators.
Third, and this may surprise you, most recessions end after about one year. In fact, the great recession lasted only 18 months officially ending in June of 2009. In other words, the margin of error of this indicator is larger than the recession itself.
Fourth, it tells us nothing about when to re-enter the market. Once fear takes over, the human tendency is to wait out the financial storm until things calm down. Unfortunately by then it’s too late and the financial rewards are gone.
So what should you do? I don’t know. But I’m sticking to spending less than I make, dollar cost averaging, and ignoring Yahoo Finance.
*Not to worry! Our children will pay it all back.
Written by Leon Tager who lives and works in Seattle writing about a better life. You should follow him on Twitter