Swedroe: Reading Inverted Yield Curves

July 27, 2018

US Yields Attractive

For example, the yield on 10-year U.K. gilts is just 1.23%. The yield on 10-year German bunds is just 0.37%. The yield on Japanese 10-year government bonds is just 0.03%.

Those low yields lead the U.S. Treasury bond market to attract capital, suppressing our longer-term yields and flattening the curve. Normally a flattening of the yield curve might signal that the market is expecting weaker economic growth. However, today that flattening could just as likely be a result of “safe-haven demand” (capital flows to the U.S., as our economy is less likely to be negatively impacted by a trade war) and the global search for higher yields.

Another important point to consider is that if the yields on longer-term bonds, such as the 10-year Treasury note, continue to remain low, perhaps causing an inversion in the two- to 10-year Treasury note yields, it’s quite possible such an event could concern the Fed that lower long-term rates are a signal from the market warning about slower economic growth.

Forcing The Fed To Act?

In turn, that could lead the Fed to slow its policy of hiking short-term interest rates, which would reduce the risk of a recession.

In fact, at the Federal Open Market Committee’s May meeting, some of the governors expressed this concern. According to the meeting’s minutes, “several participants thought that it would be important to continue to monitor the slope of the yield curve, emphasizing the historical regularity that an inverted yield curve has indicated an increased risk of recession.”

It’s also possible lower yields may be attributable to a lower neutral interest rate and low term premium (the additional return required by investors as compensation for the additional risk of holding longer-dated bonds) because of more stable inflation expectations than in the past.

There’s one other point to consider regarding the possibility of an inversion of the yield curve. As the Fed continues to unwind its more than $4 trillion of balance sheet assets, it is quite possible the reduction in liquidity will lead to an increase in the term premium, preventing that feared inversion.

Active Hasn’t Exploited This

Finally, there’s no evidence that active managers have been able to exploit any signal provided by well-publicized evidence on the predictive nature of yield-curve inversions. If there were any evidence, we would see it in the annual S&P Dow Jones Indices versus Active (SPIVA) scorecards. But none exists, in either the stock or bond market. Remember, if information is well-known, any predictive value it contains is already built into current prices. Thus, it is unlikely you can use it to generate outperformance.

Investors fail to differentiate between information and value-relevant information, trading on what is nothing more than information that has no value. Certainly, if you hear it on TV or read it in the newspaper, it is far too late to act on it.

Summary

There will always be something for investors to worry about, which is why Warren Buffett warned that once you have ordinary intelligence, success in investing is determined far more by temperament—the ability to ignore the noise of the markets and adhere to your well-thought-out plan that incorporates the risks of negative events.

Hopefully, your plan reflects the certainty that negative events, including nonforecastable Black Swan events, will occur with a high degree of regularity, and ensures that you are not taking more risk than you have the ability, willingness and need to take. Getting that right increases your ability to ignore the noise of the market, and raises the odds that your head will be making investment decisions, not your stomach. I’ve yet to meet a stomach that makes good decisions.

Lastly, ask yourself this question: Is Warren Buffett spending even one minute worrying about a yield-curve inversion? The answer almost certainly is no, because he has said he has not even looked at, or listened to, an economic or market forecast in more than 25 years. One of the great anomalies in finance, which I point out in my book, “Think, Act, and Invest Like Warren Buffett,” is that while investors idolize Buffett, they not only fail to follow his advice, but often do the exact opposite, to their great detriment.

Post Script

My colleague, Jared Kizer, also looked at this issue. He analyzed the data and found the equity premium following inverted yield curves was still positive over the following three- and five-year periods, though a bit lower than the historical average.

For those worried about high valuations at the same time as an inverted yield curve, Jared found there was no correlation with returns when this was the case. In other words, there was no predictive value.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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