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The Yield Curve: Why We Care

December 6, 2018 | Category: Articles

Market Trends

 

The Yield Curve

The yield curve is all over the financial news this week, but many people don’t know what it is, or why we care about it. Simply put, the yield curve is the sloping line you get when graphically depicting the yields of U.S. Treasury notes at various maturities. It is typically upward sloping because investors expect to get paid a higher interest rate for locking up their money for longer periods of time (See normal yield curve graphic below).

Normal Yield Curve

There are rare occurrences where the yield curve is inverted – meaning that bonds with shorter maturities are actually paying a higher interest rate than those of longer term bonds. This materialized this week, with the yield on the 3-year Treasury note yielding 2.72%, and the 5-year note yielding 2.70% (as of 12/6/18). The markets have reacted quite negatively as a result … but why?

The reason is because an inverted yield curve has preceded every U.S. economic recession since World War II. Technically, this refers to inversions where the 2-year Treasury yield is higher than the 10-year Treasury yield, but that isn’t going to stop today’s financial media. A 3-year vs. 5-year inversion is good enough to sound the alarm and grab some ratings. 

Even though recessions have been correlated with economic recessions, they are not perfect indicators of market performance or the time between the inversion and subsequent decline. Note the chart below illustrating the average time between inversion and market peak. Markets often have quite a way to go before recession causes decline.    

 

Why We Care

That said, a 2-year vs. 10-year treasury inversion (if it occurs) is something worth paying attention to. Having a conversation about your cash flow needs for the next couple of years is prudent. Recessions and bear markets are realities of being a long-term investor. We have learned that trying to time those occurrences is a mistake we have promised to avoid, but we don’t want to get put in a situation where you need money and the only place we can get it is from equities that are temporarily depressed. 

We adhere to five key principals of managing money: asset allocation, diversification, tax management, cash flow planning, and behavior management. The first three are the responsibility of your advisor, and we are confident in that work. 

The final two are a team effort where your cash needs and your emotions around the market intermix with our advice. Make sure we know what you might need in the days ahead, and we’ll make sure to keep you away from any moments of panic when the headlines are depressing. Famed investor Peter Lynch said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” We couldn’t agree more.  

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.  This information should not be relied upon by the reader as research or investment advice regarding any funds or stocks in particular, nor should it be construed as a recommendation to purchase or sell a security.  Past performance is no guarantee of future results.  Investments will fluctuate and when redeemed may be worth more or less than when originally invested.

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