The Yield Curve, Recessions, and Zombies

Most people don’t believe something can happen until it already has. That’s not stupidity or weakness, that’s just human nature.”

-World War Z, Max Brooks

No one knows why the zombies came.  But there were many reasons why they were able to rise so far so fast and nearly drive the human race to extinction: greed, fear, and downright stupidity.  It was only through sheer, heroic force of will, by millions of people working hard and fighting every day, that allowed humanity to force its way back from the brink.

Recessions are often, all too alarmingly similar to the zombie rise in World War Z.  First, they are rarely accurately predicted, and those few out there that do predict them are usually not listened to until after the fact.  Second, they are often driven by greed, fear, and stupidity.  And lastly, they can impact everyone, even those not participating actively on Wall Street.

There is, however, one recession indicator that for the last several decades been a reliable recession predictor.  The yield curve.  The yield curve has been in the news recently because it inverted (sort of), so I wanted to take a post to talk about what the heck that means. I’m not an economist by any means, but sometimes its cool to know what the terms the talking heads are throwing around.  And after all, this blog is supposed to be about financial literacy.

First, the yield curve is based in the bond market.  Bonds are loans: you give a government entity or corporation a loan, and they pay it back over a period of time, with interest. Generally, shorter term bonds have lower interest payments than longer term bonds. There are several reason for this, most to do with risk.  For example, the longer the bond term, the more chance the entity you lent might go out of business (CNBC reported the average life span of companies is now under 20 years).  Even cities (municipal bonds) can go bankrupt.  Another reason is that market conditions might change such that locking up your money for a long amount of time at a certain interest rate becomes foolish (like if interest rates rise)!  And people just want access to their money, and a long term bond makes this more difficult.

If you plot the interest rates a single entity, like one corporation, or the U.S. Treasury, on a graph, against the term of the bond, you get a curve.  This graph, or curve, usually slopes up, the longer the term, the higher the interest.  On occasion, the graph slopes down: thus the dreaded inverted yield curve.

The reason the inverted yield curve is so feared is that many economists view it a remarkably accurate indicator for when a recession will occur. According to Reuters, an inverted yield curve has reliably predicted every recession in the past 50 years, with only one false positive.  Some argue that such an inverted yield curve doesn’t just forecast a recession, it actually causes one.

There are several reasons why the yield curve inverts.  One is rising short-term interest rates.  As the Feds raise short term interest rates, the short-term bond rates naturally rise–sometimes the long-term bond rates don’t follow. Inflation is another factor.  If investors think that inflation will not rise, they will accept lower long-term rates without fear that those returns will be destroyed by rising inflation. Another is what direction investors think the economy is heading.  If investors believe the economy is heading towards recession in the near-future, they will want to buy long term bonds to lock up their money at the rate it currently is at  and avoid short-term bonds and having to reinvest that money soon in a difficult market.  This premium on long-term bonds decreases the yield those bonds give (supply and demand) because more people want to buy them. These are just a few of the factors that might lead to an inverted yield curve, and I included them just to give you some general context.

The yield curve is not currently inverted.  In early December part of the yield curve did invert, U.S. Treasury bonds for 2 years had a higher yields than 5 year bonds.  This yield curve actually inverted again and is currently inverted (although the media seems to have moved one).  But the one economists usually look to is the 2 year as compared to the 10 year as a reliable recession indicator.  Even if that yield does invert, the takeaway is not that you should run for the hills, sell all your stocks, and invest large amounts in canned goods.  First, no one is sure that an inverted yield curve will actually lead to the next recession, although if history is a guide, it is likely.  More importantly though, an inverted yield curve doesn’t indicate how soon a recession will come (it could be months, even years), how bad it will be, or how long it will last. So it may not be a good idea to base your financial plan on the yield curve alone.

That said, it is good to be aware of an inverted yield curve and what it might mean. Because the more aware you are of a possible impending apocalypse, whether it be economic or zombie, the better prepared you can be.

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