TheMoneyGeek Unplugged

When I was starting out in the financial planning business, I used to listen to smart people who spewed out catchy phrases like “inverted yield curve”, “risk-free rate”, and “henway”. Back then, I didn’t really understand much of the lingo, so I was fortunate that all this “gibberish” was only a web-search away. In my discussions these days, I try and avoid jargon as much as possible and strive to distill financial concepts into their simplest components. Today is one such attempt to explain the inverted yield curve and its effect on the economy and markets.

This so-called “best” indicator of a future recession, the inverted yield curve, is not perfect and doesn’t provide an exact time or date. But economists have found that an inverted yield curve can be a warning sign of an economic downturn to come.

Again, an inverted what??? The yield curve is a line graph of the yield (i.e., interest rate) of treasury bills (bonds) from the very short term—one month, three months, six months, 1, 2, 3, 5, 7, 10 and all the way out to 30 years. A normal curve is sloped upward—for obvious reasons: the longer the maturity of the bond, the more the borrower should have to pay to compensate you for the risks of inflation and future interest rate movements. The 3-month treasury bill should pay at least incrementally more than the 1-month treasury bill, and on up the maturity range.

Deviations from this obvious hierarchy, called “inversions”, are rare—as it turns out, just about as rare as recessions. This would be akin to walking into a bank and accepting a lower interest rate on a 2-year certificate of deposit (CD) than on a 1-year CD. Few would ever do that (especially since the penalties for early withdrawal are a bit steep).

Since 1955, long-term bonds yielded less than short-term ones before every single U.S. recession. Nobody knows exactly why a spate of market illogic should be followed by economic pain; there are theories, but the cause/effect is uncertain.

Unfortunately, the inversions in the past have occurred anywhere from 6 months to 24 months before the actual recession, so this is not exactly a precise timing mechanism. But perhaps we should consider the next yield inversion as a time to buckle our seat belts on the investment roller coaster.

So where are we now? The above chart shows the current yield curve (red) compared with a week ago (blue), a month ago (green) and a year ago (orange). As you can see, the curve has flattened in the past 12 months, not to the point of inversion, but certainly a narrower spread (i.e., difference between yields). If you want to watch to see if there is further flattening, here’s one website that tracks the curve in real-time: https://www.bondsupermart.com/main/market-info/yield-curves-chart.

Now, when someone utters the phrase “inverted yield curve”, you can nod in understanding. And if they ask what’s the risk-free rate, you can tell them it’s the current yield on the 10-year treasury note.

Finally, if anyone asks “what’s a henway”, you tell them “oh, a hen weighs about three or four pounds”.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Sources:

https://www.bondsupermart.com/main/market-info/yield-curves-chart
https://www.forbes.com/sites/johnmauldin/2018/05/01/almost-all-recessions-began-6-to-24-months-after-the-yield-curve-inverted/#2550ecfa6742
 https://thefelderreport.com/2018/04/26/how-the-flattening-yield-curve-could-lead-to-a-bear-market-for-stocks/
The MoneyGeek thanks guest writer Bob Veres for his contribution to this post

You probably know the well worn disclaimer in the investing world, “past performance is no guarantee of future results.” It’s essentially how many investment firms wow you with statistics about their past performance, only to remind you that your future results may never match theirs. OK, fair enough, so how about present circumstances? Do they portend the future?

It’s human nature to focus more on the present than the future, which is in line with our basic instinct of survival. After all, if we don’t take care of the here and now, there may not be a future, right?

Marketing departments know this! Many things in life are about experiencing pleasure today, and pushing the cost of that pleasure into the future (credit cards anyone?). Drive off with the car with zero dollars down, and pay over 84 months. Go ahead–have another piece of cake – you can work it off later. No problem.

Many decisions investors face, have similar tradeoffs. Buy a new car or put more money into retirement? Take another vacation or fund the college account? And the further out the consequence, the less weight we tend to give to it. This is because we have a hard time imagining the future…especially way into the future.

Smart Today May Not Be Smart Tomorrow

We tend to extrapolate the present into the future, as if things will never change and will continue the status quo.

In the financial crisis of 2008-2009, many people were selling after experiencing financial losses. Some of that selling came just weeks before the market hit bottom. What would cause an investor, who desires to buy low and sell high, to sell after experiencing significant (yet unrealized) losses (i.e. sell low)? One factor is that they were extrapolating the present into the future…they couldn’t see how things would change.

Another great example is the German Bund (treasury bond). In 2016, Germany sold the 10-year Bund at a negative yield (this means that buyers were guaranteed to get back less principal than they originally put in). Those investors were certain that rates would continue going negative for the next 10 years. But here we are almost two years later and the current yield is already over +0.50%. Substantial money (principal) may be lost on this bond simply because investors extrapolated the “present of 2016” into the future.

More recently, the stock markets have struggled to continue the torrid advance that began with the presidential election in 2016, lasting through this past January. The markets had a handful of “1% days” during a low volatility year in 2017, yet so far in 2018, we’ve had more 1% days than all of 2017 as volatility has returned. While the markets haven’t yet closed more than 10% from their January peak, you’ve probably read or heard the prognosticators calling this correction the beginning of the end for the bull market. Enough investors will be scared witless of enduring another 2008-2009 selloff that they’ll sell now and probably miss the next great advance that makes another new all-time high sooner than they can presently imagine.

History May Help Here

Think about everything that has happened in the last 10 years–of course, a lot has happened. And while we may not be able to project what will happen in the future, how it will happen or when, we know – through the history of mankind – that lots of unexpected things will occur. Another crisis is always bound to come along.

The plans that we have developed for our clients prepare them for many different scenarios. They take into account their risk tolerance, time-frame and overall monetary goals and dreams.  But we don’t have to get any one scenario right. We just need to be disciplined enough to stick with the plan through both the good and the tough times.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Source: Information obtained from The Emotional Investor