Easing Anxiety if the Yield Curve Inverts

Fixed Income

Easing Anxiety if the Yield Curve Inverts

Read the weekly bond market commentary from Doug Drabik.

July 9, 2018

At this time, the Fed appears determined to carry forward with raising short term rates two more times by year’s end. The current spread between the 2- and 10-year Treasuries is 27 basis points (bp), the lowest since August 2007. As discussed last week, the Fed’s move may bring the curve to an inverted state at some point in the future (raising short rates while intermediate and long rates remain somewhat stationary) which may or may not signal a recession, but even if it does, it does not mean that the economy is about to fall into the abyss.

A generally accepted definition of a recession is a period of economic decline categorized by two consecutive quarters of falling GDP. To simplify the big picture, the best circumstances cannot continuously increase without pause or periods of retraction. A recession is not necessarily a disaster even if journalists make it seem so. Imagine taking a class with a quarterly test. Suppose your grades are as follows: 80%, 85%, 98%, 90%, 88% and 85%. By definition, you experienced 3 consecutive quarters of declining grades; yet, you still produced solid grades in any isolated quarter.

Maybe a better way to classify and think of a recession is as a warning indicator that simply states the economy is less robust than the previous half year. When the engine light indicates the need for an oil change, you don’t want to ignore it because it can signal a problem but at the same time you don’t need to panic and scrap your car. Recessions may be viewed as warning indicators that our portfolios may benefit from positioning to withstand a period of economic decline. A recession usually comes with declines in GDP, real income, employment, sales, and production.

This period has been preceded by massive central bank intervention as the Fed ballooned their balance sheet and money poured into the financial markets. Several other major central banks continue with accommodative policies. Even with the central banks’ swelled balance sheets, inflation and longer term rates have remained listless yet global interest rate disparity has kept U.S. bonds the safe haven trade.

Recessions are part of the business cycle and their impact can be mild or significant but they are temporary. Portfolio discipline has crucial significance especially in disruptive markets. A defensive approach may be to maintain a portion of core investment dollars allocated to individual bonds as a means of some protection and balance with an overall asset allocation. 

To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.


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