Let's talk about yield curves.
Investors are currently spooked by a scenario known as the “inverted yield curve,” which occurs when the interest rates on short-term bonds are higher than the interest rates paid by long-term bonds. This means people are so worried about the near-term future that they're piling into safer long-term investments.
In a healthy economy, bondholders typically demand to be paid more — or receive a higher “yield” — on long-term bonds than they do for short-term bonds. That’s because longer term bonds require people to lock up their money for a greater period of time — and investors want to be compensated for that risk. In contrast, bonds that require investors to make shorter time commitments, say for three months, don’t require as much sacrifice and usually pay less.
Why should you, as an investor, care?
The indicator that we focus on is the spread between the 2-year and 10-year treasury rates. These rates temporarily inverted yesterday which caused a lot of angst in the markets. Historically speaking, the inversion of these two points on the yield curve has been a reliable indicator of economic recessions. In fact, since 1978 this inversion in yields between the 2-year and 10-year treasuries has foreshadowed each recession in the U.S. (this has happened five times since the late 70s).
While a recession has occurred anywhere from 6 to 24 months after the inversion of the yield curve, the S&P 500 has averaged +15% over the next 18 months. As an example, the last time this part of the yield curve inverted was in December 2005, roughly two years before the next recession hit, and the S&P 500 returned +16% during that time period.
We cannot predict the timing of the next recession, but this is one of the forward-looking indicators we have been closely monitoring. The warning signal has shifted from a yellow light to a flashing red one. The good news is we have been positioning client portfolios to a more defensive stance for almost two years now and are continuing to follow that path.
We will continue to be cautious, continue to reallocate your accounts to a more conservative footing, and do our best to protect you during these inevitable storms.
Please don’t hesitate to reach out with any questions you may have, we would be happy to discuss them with you.
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