Inversion Diversion

haruspex / ha-rus-pex (noun) : a diviner in ancient Rome basing his predictions on inspection of the entrails of sacrificial animals

- Merriam-Webster Dictionary

If you watch or read a lot of financial news, you’ve probably wondered at some point if a market commentator is more akin to a haruspex (see above) than a real expert – desperately attempting to predict the future of the markets based on the economic indicator du jour. Well, today that economic indicator under inspection is the current shape of the US yield curve (Technical Note: The yield curve we are referencing here is the difference between the 10-year US Treasury yield and the 3-month US Treasury Bill yield), which for at least a brief moment was recently considered “inverted.”

At this point, you are likely asking yourself “what is a yield curve inversion AND is it really as ominous as the pundits make it sound?” We will attempt to answer this in two parts: 1) a brief, but necessary, Yield Curve 101; and 2) a summary of important conclusions about yield curve inversions.

To understand the yield curve, imagine a timeline with a notch representing each year from now until 30 years into the future. Each notch along that timeline has a dot commensurate with the annual interest rate one would receive for investing for that set duration of years (using the x-axis). Generally speaking, a “normal” yield curve would be a line connecting those dots in a softly increasing slope (going uphill as you move from the short-end of the curve on the left to the long-end of the curve on the right). This upward sloping interest-rate curve is healthy because it posits that the expectation for future economic growth is positive (i.e., there must be a sufficient incentive to put money in savings vs. investing in the economy through corporate enterprise).

Another way to look at why the upward sloping yield curve is healthy is by using the old “3-6-3 rule” of banking: borrow at three percent (deposits), lend at six percent, pocket the spread and hit the golf course by 3pm. It was a good life being a banker. But more importantly, it indicates a healthy functioning of the economy – where there is an incentive for banks to make money lending capital and companies to invest in growth.

In contrast, an inversion implies the opposite. Now picture a downward sloping line where short-term interest rates are higher than long-term interest rates. Put simply, the bond market is saying that the future of the economy is not looking so great (better to lock-in lower savings rates for several years than take the risk investing in the economy). Add to that the unfavorable economics of borrowing at higher rates only to lend atlower rates in the future (again, the bank model) – not an exciting prospect for banks or investors.

May 19 resize

By now, you’ve likely already heard the assertions that an inversion implies that a recession is imminent. It would be reasonable for someone to make this conclusion when hearing that about 75% of inversions in history were followed by recessions, with 100% of the last seven recessions occurring after an inversion.

We’ll be real with you and say a recession is definitely out there on the horizon (well, they essentially always are), but we’d be kidding ourselves and you, as trusting clients, if we said we had some reliable tool to let you know when it will occur (wouldn’t that be haruspicy?). But here’s what we can say about inversions:

  1. It doesn’t count as a real inversion unless the curve stays inverted for more than just a few days at a time – we’re talking multiple months of consistent inversion status for this to actually get credit.
  2. If it is a real inversion, then a recession is still likely 12-18 months out based on prior history.
  3. To grant credence to the inversion as a predictor (vs. one of the false-positive head fakes), other leading economic indicators should be flashing RED – which is not currently the case in the U.S.
  4. Not to say this time is different, but we are in the new frontier of central bank policy with low interest rates across the globe (and in some countries, negative interest rates). It’s a crazy world right now.

If this were a real inversion with an impending recession, what do we do about it? Well, that’s when we reiterate our sound philosophy on portfolio management (as we have been applying for our clients). First, determine an appropriate balance of stocks and bonds so that you don’t risk more of your money than you can afford to lose. Second, buy high-quality investments and stay extra disciplined when excess market fear turns to greed. And third, maintain that appropriate balance through the cycle by prudently trimming your stock exposure back to target as stock performance continues to outrun the steady, albeit slower, return on bonds (and, might we add, this also matters in reverse when you can sell safe bonds to fund investments in stocks on the cheap).

Not to risk making it sound easier than it actually is, we do have to remind our clients that setting an appropriate investment strategy is only half the battle – sticking to it when the market pendulum swings too far to the upside and downside is when things get challenging. That’s where our professional guidance and experience will provide the most value – we are passionate about helping clients through the cycles.

Thank you for your continued trust and confidence. Please feel free to send us a message or give us a call anytime. We’re standing by to be your guide through anything the market sends our way.

Sincerely,

Norris, Perné & French

Step One

Step Two

Our Mission: Partnering with our clients to grow and preserve their wealth through clear, sound, and trusted investment counsel.