My Financial Musings...What is in inverted yield curve and who cares?

Investors care.  Consequently now could be the time to don a mechanics overall, open the bonnet and have a good look at what is happening in your portfolio.  Amber lights have been flashing for a few weeks now and most investment portfolios could do with an MOT.    

The S&P 500 is down 10% year to date and the NASDAQ index has lost 18%.  Markets are reacting to rising inflation +7% in the UK and 8.5% in the US.  Even prior to the war in Ukraine, energy prices were rising but are now spiking alongside food prices, leaving consumers worse off as prices of most goods rise.   

As a result of these warning signals central banks are walking a tightrope. The strategy is to raise interest rates to counter rising inflation while knowing that if rates go up too fast it could slam the brakes on the economy.  That in turn could tip us into a recession.  The rose tinted view is that the Federal Reserve will raise rates sufficiently to counteract rising inflation and that inflation will fall back to 3% over the next 3-5 years.  The brief inversion of the Yield Curve tells us that the market thinks otherwise and that brings me to the technical part.

Thirty year US government bond rates are yielding 2.95% whereas two year US government bond rates are yielding 2.68%.  Only fractionally more.  This matters as generally shorter dated bonds have a lower yield than longer dated bonds.

The reason for this differential is that investors demand higher returns for taking on the risk of investing longer term, reflecting the risk of possible higher inflation and future interest rate rises.  The traditional shape of the Yield Curve (as the difference of yields over time is known) is sloping gently upwards.  Today it is nearly flat.  This flattening of the Yield Curve indicates investors expect slower growth in the future.   

Alarm bells rang earlier this month as the yield curve briefly inverted -  ie shorter dated two year bonds generate a higher yield than longer dated bond ten year bonds– a sustained inverted yield curve has been the harbinger of six out of the last eight recessions since 1960-70s according to a number of studies (*). 

If in a recession inflation is sustained at a higher rate than economic growth, this is known as stagflation which we last experienced in the 1970s and it was not a comfortable ride for investors.   What can you do?

Maybe it is time to review your investments with your financial adviser and discuss the merits of holding resilient assets and focussing on businesses with pricing power.  

If you have completed a MFV course with me before, then please do join me for a Complimentary Workshop on Past Recessions and Market Trends.  Contact me by email sarah@myfinancialvoice.co.uk  for available dates. 

https://www.chicagofed.org/publications/chicago-fed-letter/2018/404

https://www.colotrust.com/the-shape-of-the-u-s-treasury-yield-curve/