The “Swoosh" of the Inverted Yield Curve

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by Ralph Cole, CFA
Director, Executive Vice President of Research  

During the fourth quarter of each year, our investment team shares their collective research and analysis to determine our investment outlook communication to clients. We were in consensus regarding our 2019 theme, “The Fasten Seatbelt Sign Is On,” and this week’s market volatility reinforced that we landed on the right message. The Dow was down by 600 on Tuesday and then rallied by nearly 1,000 points within 24 hours.

Included in our 2019 theme was the thesis that we were late in the economic cycle, growth was slowing and the Fed was likely to continue normalizing short-term interest rates. As economic cycles head toward latter stages, equity volatility tends to increase. This anticipated activity has been amplified by the ongoing trade war between the U.S. and China.  

While one would expect tariffs to have an inflationary effect in the short term, they actually appear to be leading the way for lower growth expectations in the future. The actual impact of tariffs is small, but they do reduce absolute levels of trade. Slower growth expectations have thus led to dramatically lower interest rates. The yield on the 10-year Treasury is down to 1.70 percent, which is actually lower than the current three-month Treasury bill by .25 percent or 25 basis points. These yields have triggered an inverted yield curve, which may be foreshadowing a slowdown.


Source: Bloomberg

An inverted yield curve has historically signaled an economic recession over the next 12-to-20 months. This indicator has a very good batting average historically. The last time an inverted yield curve was not followed by a recession was in the 1960s, when rates were low. With this in mind and current rates at extraordinarily low levels, there is the possibility that the curve may be a less ominous recession warning this time. No doubt this inversion has caught our attention and we continue to monitor in the context of other economic indicators.

Is it really different this time? Absolutely. Over $15 trillion in foreign government debt trades at negative yields meaning, you actually pay interest to the issuing entity for the privilege of buying their debt. It certainly makes the positive yield of U.S. debt very appealing to investors around the globe. This external demand will continue to keep yields in the U.S. abnormally low. We currently don’t see a recession in the U.S. during the next year.   

One of our four key points in our 2019 Investment Outlook was, “Finding Smoother Air.” We continue to follow our late-cycle playbook, reducing risk within portfolios. We have upgraded credit quality across our bond portfolios and removed our cyclical tilt in equity portfolios. We continue to be neutral stocks versus bonds in our balanced portfolios, but with the yield curve signaling a possible recession, our next move could be to go underweight equities.

Week in Review and Our Takeaways

  • Equity markets continue to be volatile as fears of a trade-related slowdown rippled throughout global markets

  • An inverted yield curve has signaled the possibility of a recession on the horizon