Will we have have a recession? The yield curve weighs in.

August 23, 2019

The media has been reporting that a recession is coming. And the term "inverted yield curve" is surging in Google searches. People are wondering how they'll be affected.

First, understand that there are many signals that foreshadow a recession. None of them are guarantees, but one that has historically been reliable is the inversion of the yield curve (1). The yield curve inverted recently, and cable news prognosticators started talking about it incessantly, in part because they are on the air too much and don't have enough content to fill the day.

The yield curve inverting means that people are willing to take less risk to own long term bonds than short term bonds. Normally this does not make sense - a financial bond that you own for a long time inherently has more risk, as more could go wrong over that period. Hence normally you get paid more to take that risk as the investor.

But when people think the economy is going to enter a recessionary phase, they 1. get scared and look for safe, long-term bonds and 2. assume the Fed will cut interest rates, making the demand rise for longer bonds, as those bonds now pay the higher rates for long periods of time. The rise in demand increases the price, which decreases the yield to maturity of the bond. The yield to maturity is the total annual return if the bond is held to maturity.

As a result, the percentage rate on the bond that the investor will make each year for shorter bonds rises above the longer bonds. This is the yield curve inversion you are seeing in the news.

Does this mean we are going into a recession? Maybe. The last seven times the yield curve inverted, we did go into a recession. But on average it took 15 months for the economy to do so, and in the meantime, the S&P 500 *rose* 15% in the 18 months following the inversion. (2)

But maybe not. Just because something has happened repeatedly in the past is no guarantee of the future. These are macro-economic systems after all. And to make matters more complicated, if you attempt to time investments based on macro-economic forces, you are overlaying an additional complex system of "how a market reacts to macro-economic news." Predicting the outcome of this stack of complexity is a fool's errand.

If you are trying to adjust an investment portfolio now to this news, you are too late. The time to consider recession risk is long before it breaks into the media. Investing is not about reacting to moments in time, investing is about understanding what you can control, being honest with yourself about behavioral patterns, establishing a systematic process that addresses both risk and return potential, and sticking with it.

Dan Cunningham

(1) NPR: What Just Happened Also Occurred Before the Last 7 U.S. Recessions

(2) CNBC: How Stock Behave After a Yield Curve Inversion