An interest rate anomaly threatens recession. Alarms sound because of tariffs and events reminiscent of the Cold War. Dark clouds clutter the horizon.
Meanwhile, the mainstream media tell investors how to respond in uncertain times.
Beware! Advice meant for the masses is often wrong, and it cannot adequately address individuals’ unique circumstances.
This is your life. By proactively managing risk in ways suitable to your interests and address threats in ways that serve you best.
The threatening interest rate anomaly is worth a closer look because it might be the most reliable predictor of the future economy.
The threat is an inverted yield curve, observed when the Treasury’s 2-year yield exceeds the 10-year yield.
It helps to visualize the yield curve.
The “Treasury Yield Curves” graph illustrates yields by maturities at a point in time. The important thing is not absolute yield; rather, focus on relative yields by comparing same-date yields across maturities; that’s what each colored curve represents.
The blue curve is what you’d expect: Longer maturities offer higher yields because lenders demand compensation for risks they assume for longer periods. This positively-sloped curve usually prevails.
The inverted red curve is notwhat you’d expect: In August 2000, the 10-year yield equaled 5.73% and the 2-year yield equaled 6.18%.
The slightly positively sloped green curve illustrates yields in December 2018. By definition, it’s not inverted. However, the 5-year yield equaled 2.7% and the 2-year yield equaled 2.72%. That’s an inversion of just part of the curve.
Okay, that might not seem like much of an inversion. But there’s a persistent trend underway. Look at the trend here: https://fred.stlouisfed.org/graph/?g=2YEc.
After the site opens, click the “5Y” link above and to the right of the graph between “1Y” and “10Y.” The emboldened curve illustrates the 10-year yield minus the 2-year yield for the past five years. A positive difference indicates a positively sloped curve; a negative difference indicates inversion.
The difference between 10- and 2-year yields creeps closer and closer to zero. A persistent trend toward a flat or negative yield curve is the obvious conclusion from this graph.
In the same window click the “Max” link to see the historical relationship between inversions and recessions. Gray columns in the graph indicate recessions. These historical data lead to the conclusion that inversions have reliably predicted recessions because inversions preceded recessions, and recessions didn’t happen absent inversions. Just a few warnings about this conclusion:
- Sample size is small. Only five recessions and five inversions since 1980.
- Inversions did not causerecessions, they led and coincided with recessions.
- The interval between inversions and recessions varies.
- If we change the inversion definition so we use different maturities that go back farther in history, we find that not all inversions anticipate recessions. [i]
Consider the parallel between risk management improvements in vehicles and in investments. In the early 1960s, seatbelts and many of the modern protective systems did not exist. Today, thanks in part to safer vehicles, deaths from crashes per mile driven are about one-fifth what they were in 1960.[ii]In the investments field, Harry Markowitz[iii]wrote the seminal article on Modern Portfolio Theory defining investment risk in 1952. His work and those of others following him enabled more proficient risk management. Methods evolved giving investors tools to construct portfolios that manage risk and still present opportunities for growth.
We believe in the markets and how they reward thoughtful risk-takers. These investors know trees don’t grow to the sky.
We also believe the most successful investors use non-correlated assets to help manage risk; they reject so-called “guarantees” from insurance companies in favor of thoughtfully allocated portfolios.
In our opinion, you have a choice. You can react to threats as they are presented by geopolitical and economic events, or you can address threats, known and unknown, now. It’s your life, your investments, your future, your legacy. Diligent hands will rule.[iv]
[i]Bill Conerly writes a concise and authoritative article about inverted yield curves in Forbes, retrieved 17 Dec 2018: https://www.forbes.com/sites/billconerly/2018/07/14/the-yield-curve-as-recession-predictor-should-we-worry-today/#6dfaa707ba4e
[ii]https://www.bts.gov/content/motor-vehicle-safety-dataretrieved 18 Dec 2018.
[iii]Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, 7(1), 77-91.
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