How does an inverted yield curve happen?
People are motivated by the fear of loss more than anything else. This is a psychological phenomenon called “loss of aversion.”
When the possibility of losing arises, we are afraid. We remember the things we lost more than we gained (ask any gambler).
When we get scared we often make crazy decisions like selling all our investments because of a market crash or splitting up a group in a haunted house so the killer can take them out one by one.
Ordinary investors. (Source: Fanpop)When there is talk of a recession, many investors will start investing in long-term US Treasury bonds as it approaches – knowing that interest rates on other assets such as stocks will soon drop.
As more people start buying long-term bonds, however, the Federal Reserve responds by lowering the yield on those stocks. And since people aren’t buying as many short-term US Treasury bonds, the Fed will make those yields. more to attract investors. Repetition:
- Bonds are considered safe.
- People who are not confident in the market will move more money into bonds.
- As more people invest in bonds, their rate of return falls.
This is basic supply and demand. The less people demand a bond, the more financial institutions like the Fed will make that bond more attractive to investors.
A good example of a yield curve inversion occurred before the 2008 housing market crash in December 2005 – almost three years before the crash.
The Fed raised the federal funds rate to 4.25% for a number of reasons.
In particular, they knew that there was a rising price bubble among certain assets such as housing, and they were concerned that low interest rates were causing this.
So when the funds rate was raised to 4.25% in 2005, it caused the two-year US Treasury bond to yield 4.4% while the longer seven-year bond yielded only 4.39%.
The curve soon began to invert sharply as the recession began to approach and investors continued to invest more in long-term bonds.
Finally, the United States found itself in a recession after the housing market collapsed almost two years later.
Note: An inverted yield curve was not the cause of the recession but a symptom of it. Think of an inverted yield curve like a cough or fever in a serious illness.
The last seven recessions the country has seen were preceded by an inverted yield curve — and many experts agree that another inversion of the yield curve may be on the way.
While an inverted yield curve is a good sign that there is a recession and the next bear market is on the way, what does that mean for you? What’s a non-Wall Street person to do when you see an article like this?
(Source: South China Morning Post)
How an inverted yield curve affects you
First, the good news: Inverted yield curves don’t last forever. In fact, the last one lasted until the summer of 2007 when it flattened out and began to return to its normal state.
An inverted yield curve has consequences for you and can affect you in many different ways depending on your financial situation.
For example, if you are a long-term investor and have money tied up in long-term bonds, you will see interest rates on those bonds lower than on short-term bonds. This can be scary for any investor who is trying to plan for the future, as you get less income due to lower interest rates.
Also, if you bought a home with an adjustable rate mortgage, it’s more likely that your interest rate schedule depends on the short-term bond interest rate.
That means it will match bond interest rates when they fall and rise. So if those rates are high, you will end up paying more interest.
(Pro-Tip: I suggest you get a fixed rate loan to prevent situations like this from happening.)
If you REALLY want to make sure you are protected, be sure to check out my article creating an all-weather portfolio.
What should you do if an inverted yield curve occurs?
Whenever it comes to recession, depression, random Facebook friends asking you to join their MLM schemes, or any other negative external forces in your life, always remember one thing:
And one thing you can control to help you be ready if an inverted yield curve happens is to create an emergency fund.
This is the money you save for financial disasters like medical emergencies, car or home repairs, and, you guessed it, the inverted yield curve that characterizes a recession.
If you ever find yourself in a situation where you lose your income or experience a major financial emergency, it’s good to have a safety net to fall back on.
We’ve written all about emergency funds before, so I won’t go into too much detail. But the basics are simple:
- Calculate the cost for three to six months. If you are laid off because of the recession, it will take time to find another job. That’s why you need to take care of your living expenses. This includes things like rent, mortgage payments, car payments, utilities, and groceries.
- Use a savings account. A sub-savings account is a small account that you create alongside your regular savings account that is set aside for specific purposes. By using a small savings account, you are more likely to set aside money for your emergency fund due to psychology. Read more about it in our savings accounts article here.
- Automate your finances. This is my automatic investing, saving, and spending system. When you receive your check, your money goes where it needs to go.
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The things you’ll learn in this Master Guide will set you up for financial success beyond worrying about an inverted yield curve.
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Frequently Asked Questions:
Why does an inverted yield curve predict a recession?
An inverted yield curve occurs when long-term bonds yield less than short-term bonds due to a negative economic outlook. This is against the norm. Every major recession in the past 100 years has been preceded by an inverted yield curve. Be sure to build an emergency fund to be prepared if it happens again.
What causes an inverted yield curve?
When confidence in the markets decreases, people look for safe long-term investments such as long-term government bonds. This causes the yield of long-term bonds to fall below the yield of short-term bonds, causing an inverted yield curve.
Is the yield curve now inverted?
Not yet, no. The last modification was in August 2019.
How often does an inverted yield curve predict a recession?
An inverted yield curve does not always mean that there will be a recession, but there has been an inverted yield curve before every recession in the last 100 years. It is the most reliable indicator that a recession may be coming.