Let’s talk about the most exciting topic you could possibly bring up at a dinner party. This topic trumps trade wars, climate change, border walls, and even Russian “meddling.” I’m talking about arguably the most reliable predictor of recessions and one of the most fluid pieces of perpetually changing art in modern history.
The YIELD CURVE!
How 'bout that for a dramatic lead in? If you are like most investors, this means nothing to you, and that’s okay. It is certainly nothing to be ashamed of. Before I got into the business, I had no idea what the yield curve was or what it looked like.
Without further ado, here are the charts:
A normal curve is simple and intuitive to understand. If we think about all of these images in terms of US Treasuries, the time to maturity would be on the X-axis and the yield would be signified by the Y-axis. On a normal curve, the shortest maturity T-bills would signify the far left side of the curve, while the 30-year Treasury Bond find itself on the furthest right side of the curve. Naturally, on a normal curve, yields would steadily increase as maturity increases.
Flat Curve Once again, this type of curve is simple to identify. Interestingly enough, the curve has never actually been flat. There has not been a time in modern history where all maturities of Federal Debt have yielded the exact same amount and the exact same time. In finance, we commonly refer to a “flattening curve,” which simply means longer maturity bonds are seeing their yield drop and shorter maturity bonds may either see their yields stay the same or increase to some degree. This is the environment we are currently experiencing.
Humped CurveThis type of curve is fairly rare. This is when short maturity bonds have a higher yield than long maturity bonds, but a lower yield than intermediate bonds. For example, the 2-year treasury note may yield 2.5% while the 5-year treasury note yields 3%. This all seems normal until we notice the 20-year bond’s yield of 2.25%. You may see something like this occur in a period of rapidly increasing fed funds rates and extremely high volatility on global markets. Foreign investors who are starved for yield will chase the long end of the curve and create enough demand to temporarily push the yields below much shorter dated debt.
Inverted CurveEveryone loves talking about yield curve inversions. At least the folks on CNBC do. A traditional inversion would signify a bad economic environment is on the horizon. Similar to a humped curve, we would need to see incredible demand for long maturity bonds and very little demand accompanied with tightening monetary policy. This is a scenario where you literally get paid less interest to own a bond with 30 years to maturity than a 2-year treasury note. I would like to point out that the most widely followed curve for market predictions is the 2/10 year spread.
Recent InversionWe recently experienced an inversion, but it was not a traditional inversion. We saw the 2/5 year curve invert, and it got people talking. Although most pundits argue that this spread is not nearly as important as the more liquid and traditionally followed 2/10 year spread, one would be foolish to not at the very least pay attention to it. The last 2 recessions were predicted by 2/5 inversions, roughly 2 years before the recession started. This is just a little food for thought as you start thinking about your asset allocation and tactical positioning for 2019.
We are not suggesting anyone read too much into recent events, but it is important not to bury your head in the sand.
I am eternally grateful for the opportunity to share my knowledge with others. Writing has become very important to me and I truly appreciate all of you who take a few minutes to indulge in my ramblings. I wish you all a healthy and prosperous 2019!
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