When a yield curve “inverts,” it means that short-term loans have become more expensive than longer-term loans. This sort of inverted yield curve happened on Dec. 3, as the effective interest rate paid on three-year government notes went above what was being paid on the five-year issue.
That’s not a full inversion — something that has signaled a recession with great accuracy ever since World War II. A full inversion would mean a higher rate on the two-year note than that of the 10-year note. The spread between two-year and ten-year was .15% on Dec. 4.
But the good folks at Vanguard now believe inversion will happen. Rates on long-term loans are low because technology is deflationary and keeps inflation down. Rates on short-term loans are rising as the Federal Reserve seeks to “normalize” the price of money, i.e., charge a realistic price for it.
But what does this mean for your portfolio?
Competition for Money
The first thing it means is that you can now get good deals on short-term government bonds. A three-month government bond, for instance, now yields 2.4%. That’s better than the yield on many popular dividend stocks, and there’s less risk of losing your principal.
It’s better, in this case, to buy your paper directly from the government, through your broker, than to buy a short-term bond fund like the JPMorgan Limited Duration Bond Fund (MUTF:ONUAX). Funds roll over their paper, so you’re getting a lot of older loans, not today’s higher rate. But it’s still better than cash.
Competition for your money also means dividend stocks become less attractive, for two reasons. First, the 1.58% yield on a stock like Apple (NASDAQ:AAPL) is now a lot less than you can get with short-term government paper. More important, the signal of a recession ahead is going to depress stock prices, even if a recession doesn’t happen, and companies will be paying more on their loans as well.
The Paper Mountain
Defaults are the real fear.
Private equity has been borrowing money with both hands for years because money was cheap. As money gets more expensive, and returns get harder to come by, it gets harder to repay the loans.
Analysts have been warning about these “debt bubbles” for years. Corporations are said to be in a debt bubble, with $9 trillion outstanding. Student loans are said to be a debt bubble, with $15 trillion outstanding. As loans default, capital for new loans dries up and a recession becomes a self-fulfilling prophecy. Global debt is now $247 trillion, more than three times the global GDP.
Writing off debt is the first step in a recovery, but the holders are going to demand pain first, and that’s what makes recessions.
What to Do?
When loans go bad and times are tough, it’s the person with ready cash who comes out the winner. Warren Buffett of Berkshire Hathaway (NYSE:BRK.A) did some of his best deals during the last financial crisis.
Having cash in short-term investments that can be quickly liquidated, without a loss, and recognizing that cash itself is an asset class, are the keys to staying afloat in tough times.
I may sell some index fund holdings and accept losses in equity value for the sake of safety. Of all the stocks out there, I now like the big banks like JPMorgan Chase (NYSE:JPM) best, because they have balance sheets that can take big write-offs.
For young investors, take some gains now but stay in the market. If the coming recession is bad, you may even find homes becoming affordable.
Dana Blankenhorn is a financial and technology journalist. He is the author of a new mystery thriller, The Reluctant Detective Finds Her Family, available now at the Amazon Kindle store. Write him at danablankenhorn@gmail.com or follow him on Twitter at @danablankenhorn. As of this writing he owned shares in AAPL.
