Inverted Yield Curve and the Market

On Wednesday August 14, 2019, the market dropped a dramatic 800 points. All the talk was about the yield curve being inverted.

What is the Yield Curve?

The yield curve displays the relationship between long-term and short-term Treasury bonds. Long-term yields (such as 10-year Treasuries) are normally greater than short-term (2-year) yields. This is because, like CDs in a bank, you are tying up your money for a longer period with long-term bonds and expect to be compensated with a greater return. When the 10-year interest rate is less than the 2-year rate, the yield curve is said to be inverted.

Why is an Inverted Yield Curve Bad?

Banks and lenders borrow money from depositors and offer short term rates. They take this money and loan it out for long term investments (mortgages and capital construction). If the yield curve is inverted, they have less incentive to loan money and get less in return than they pay for the money. Investments in the economy can dry up and growth is curbed.

Does an Inverted Yield Predict a Bad Stock Market?

Yes and no. An inverted yield curve is a pretty good indicator of a future recession. But there are a couple of caveats:

It doesn’t tell when and how long until a bear market will occur. The last time the curve inverted was in 2005. The market continued to advance another 30% before it turned into a bear market, 3-years later.
A one-day (just several hours) inversion of the yield curve is not enough to proclaim that the curve is inverted. How long it must remain inverted is conjectural. The news channels failed to mention this important point, that the curve was not inverted for even one full day.
I view an inversion as storm clouds on the horizon but not overhead. How fast are the clouds moving towards us is unknown. And one cloud in the distance by itself isn’t a good predictor of a storm.
It does mean however that you must carefully keep your eyes on the horizon to see if the clouds, along with other signals, are getting darker and closer.

What’s the Good News?

While the rest of the world is on edge, the United States is doing well. Right now, this is the best place to invest. So foreigners and ourselves are investing heavily in the U.S.
Consumer spending constitutes two-thirds of the GDP and it rose solidly in the second quarter of 2019 and appears to be doing well.

What’s the Bad News?

The tariffs imposed by President Trump are a definite drag on the U.S. economy. The only officials I know who are saying they aren’t are the president and Peter Navarro, our trade negotiator.
As evidence of the negative impact of the tariffs, today (August 15, 2019) President Trump Tweeted that he would consider negotiating with China. The market immediately started to advance. But then President Trump said that any negotiation would have to be on his terms. In the blink of an eye, the market immediately dropped over 100 points!
The biggest problems are overseas. Economic output in Germany contracted and a report on factory output in China came in lower than expected.
But proclaiming that the tariffs are hurting China more than us is like saying that they lost five fingers, but we only lost three! Tariffs are never good and trade wars are not easy to win! There are no winners.
A big risk is that all the anxiety can create a self-fulfilling prophecy.

Bottom Line

I continue to remain cautiously optimistic but more defensive. Portfolios are diversified but weighted less heavily in certain sectors, such as the consumer discretionary sector.