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The yield curve (partially) inverted. What do I do?

As of this writing, the US yield curve has partially inverted. What does that mean? What should you do? Short answers: nothing we can reliably predict, and nothing you shouldn't already be doing, respectively. If you already knew that, you can skip the rest. Want more? Read on.

What's a yield curve?

The "yield curve" is a graph of current bond interest rates, where the X-axis is the term of the bond and the Y axis is the interest rates. Here's a chart of recent yield curves:


Generally speaking, the line slopes up. This makes sense: the longer the bond term, the higher the risk, so the more investors should get paid for purchasing the bond. However, if you take a look at the red line, you'll see that there's actually a small dip between the 3Y and 5Y yields.

That's a (partial) inversion, and it freaks people out.

Why does a bond curve invert, and what does that mean?

Simply put, a bond curve inverts because investors think that interest rates are going to go down in the future. That's pretty straightforward, and it doesn't necessarily sound bad on the surface, right? Interest rates go down, the value of my bonds goes up!

The problem is that there's a perceived correlation between inverted yield curves and a coming recession. What causes interest rates to go down? Among other things: (a) lower productivity, and (b) lower inflation due to an excess of goods and services. Both of these happen in a recession.

For example, take a look at the graph below.The blueish line is the growth of $1,000 invested in the S&P500 over time, and the orange line is the spread between 10-year and 2-year treasuries -- when it goes below zero, that's a clear inversion, as indicated by the black vertical lines.

US Treasury yield curve data (monthly) obtained from FRED, Federal Reserve Bank of St. Louis. S&P 500 Index © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results. If you're reading this, you're exactly the type of person I love working with!

You'll notice that the 2000 and 2008 recessions were both preceded by a clear inversion. (There were also recessions in 1990 and 1981, though they're not quite as easy to see on the chart.)

This means there's a clear correlation between inverted yield curves and recessions, right? Actually, no. Count the number of datapoints in the graph above: four. Let's broaden our scope, shall we?

Yield curve inversions based on 2-year and 10-year government bond yields for each country. Yields obtained from Reserve Bank of Australia, Bundesbank, Japanese Ministry of Finance, Bank of England, European Central Bank, and US Federal Reserve. Stock returns based on local currency MSCI indices. MSCI Australia Index (gross div., AUD), MSCI Germany Index (gross div., EUR), MSCI Japan Index (gross div., JPY), MSCI United Kingdom Index (gross div., GBP), MSCI USA Index (gross div., USD.) These countries were selected to represent the world’s major developed country currencies. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. MSCI data © MSCI 2018, all rights reserved. Past performance is no guarantee of future results. If you're reading this, seriously, I'm impressed. If you have any questions about the dataset, don't hesitate to ask me.

Now we're looking at a bunch of developed countries (including the US) that had yield curve inversions over the past few decades. Looking out 36 months from a yield curve inversion, 10 out of 14 times you end up with a positive return on investing in your local stocks.

So: might an inverted yield curve mean there's a recession on the way? Maybe. Maybe not. From the data, it's hard to say.

What do I do?

The big question, of course, is: what should you do about it? Well, I'll tell you what not to do about it: don't use an inverted yield curve as an indicator to determine whether you go into stocks or bonds! Why not? Well, go back up to that second graph. See the inversion before the 2008 recession? That inversion happened in 2006. If you had sold then, you would have missed out on the gains between 2006 and 2007. And if you had then turned around and gone 100% stocks when the yield curve went positive again, in June of 2007...well, let's just say that would have been a pretty nasty ride.

"That's nice," you say, "but I'd rather hear about what I should do, not what I shouldn't do." Fair enough!

First and foremost, if you've got a large chunk of money you're going to want to access in the next 2-5 years, it's a good policy to have it in cash savings, whether the yield curve is up, down, or sideways. This includes emergency savings and big goals, like a car or house down payment. (Retirees: this does not mean you should keep 2-4 years of living expenses in cash, but that's a topic for another article. For now let's just say that there are other strategies that are simpler and just as effective.) I say "2-4 years" because that's how long it would take a well-diversified portfolio to recover from another Great Recession; a conservative portfolio would be on the low end of that, while an aggressive portfolio would be towards the high end. If you're not sure where you fall, I recommend skewing high for peace of mind.

Second: diversify, diversify, diversify. If you come away with anything from this article, I hope it's that trying to use indicators to predict future market activity is a loser's game. Your best bet is to have a diversified portfolio of uncorrelated asset classes. Own small companies and large companies, not just Apple and Amazon. Own international stocks, not just US ones. For that matter, own international bonds and real estate, now that those are more readily available.

And don't forget: it's not enough to have a diversified portfolio! You should also make sure you opportunistically rebalance between asset classes. You know how some investors like to keep cash on hand for buying stocks when the market is low? Opportunistic rebalancing does exactly that: as the prices of stocks fall, the result of rebalancing is to systematically sell bonds to buy stocks. And when the market rises again, rebalancing makes sure that you don't get overexposed to the market relative to your risk tolerance and capacity, by selling off your stocks to lock in gains and limit your exposure to volatility.

Third: if you're reading this article in a cold sweat in the middle of the night because you're worried about the current state of the markets, your asset allocation is probably wrong. "But!" you say. "I'm supposed to have 100% of my portfolio in stocks, because of my age/Jeremy Siegel/what my friend told me!" That's the logical part of your brain talking, and it's half right, but it's also half wrong. Your asset allocation needs to come partly from your risk capacity, sure, but also partly from your risk tolerance -- your emotional brain.

To put it another way: if you're investing the way you think you should, but it's keeping you up at night, then your money is in charge of you, not the other way around.

And for those of you who say, "but I took a risk tolerance questionnaire, and it says I should be in 100% stocks, but I can't sleep at night," don't worry: you're not alone! Questionnaires can be handy, especially the psychometric ones with research behind them, but times like these are where the rubber meets the road. If you can't sleep at night due to market volatility, and you've determined that you could lower your allocation to stocks and still meet your goals, you officially have my permission to do so, with one caveat: if a year from now you find yourself saying, "hey, I wish I were getting more of the sweet market returns those aggressive investors are getting"...resist the temptation to return to your previous aggressive portfolio. If it's too aggressive during scary times, it's too aggressive, period!

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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