The Fed has pitched us a tough one…
Understanding the Yield Curve
First, let’s talk about the yield curve. When the yield curve is behaving normally, you’ll earn more on long-term government bonds than on short-term ones.
So if you were to buy a 10-year government bond, it would pay you a higher rate of interest than a bond that matured in two years.
This makes sense. After all, you should get paid more for taking more risk.
The yield curve is now inverted. That means you will make more money from the two-year bond than from the 10-year bond.
This implies that the economy will be weaker in the years ahead, as you are now getting paid less money to lock up your money for the long term.
Learning From Yield Curve Trends
In the past, whenever the yield curve has inverted, a recession has followed within a year or two.
What this means for you is that your money will earn less from fixed income going forward. This also happened during the period after the Great Recession. At that time, the Federal Reserve took rates down to next to nothing to stimulate the economy.
So you must prepare yourself to earn less income from your low-risk investments like certificates of deposit (CDs) and Treasurys. You should also shift into high-quality dividend-paying stocks that you plan on holding, not trading.
After all, the dividend yield on the S&P 500 is now higher than the yield on the 30-year Treasury for the first time since 2009.
There are a lot of reasons that the yield curve could have inverted. For example, we’ve begun to see lack of confidence in global economic growth. This is due in part to trade wars, Brexit, and slower growth in countries in Asia and Europe.
The U.S. economy is the shining star for now, but growth in the U.S. is at risk due to the massive amount of political uncertainty that is emanating from Washington.
Everyone hates uncertainty – investors, the general noninvesting public and the markets alike. We hate it because it makes us pull back from investing and from spending and creates a slower growth environment.
That is bad for everyone.
A Potential Saving Grace
The only saving grace that I see this time is that the inversion is very mild right now and may be caused by unique external factors – not trends we’ve seen before.
(Of course, I’ll couch this by admitting that it’s never a good idea to say, “It’s different this time.” Usually, it isn’t! But it is possible that we are experiencing a special situation.)
Wood-knocking aside, one factor worth watching is the behavior of interest rates around the world. For the most part, the rates in Europe are negative. This means that people are paying their banks or governments to hold their money instead of the other way around.
That forces people to invest outside these countries in search of positive returns – which puts the U.S. in the crosshairs. We have a strong currency, and we are paying positive yields on cash.
Investors in other countries are plowing money into long-term Treasurys to lock in yields, no matter how paltry… it’s better than losing money.
Today, that creates a situation where there is a lot of demand for the long bond. That’s why the yield is sinking lower and the price is rising higher. That creates added pressure, inverting the yield curve.
How to Hit a Home Run
Therefore, while it’s true that the yield curve normally signals a recession ahead, it may not be as accurate this time. And remember, a recession means growth is slowing. It doesn’t always mean that growth is negative.
The U.S. economy is in great shape right now. Don’t let panic-ridden headlines keep you from stepping up to bat – with the right investments, you can still score.
Just keep an eye on Washington… it’s doing its best to make you strike out.