Should You Care About the Inverted Yield Curve?

If consumer spending slows and economic growth declines, then there's a cause for concern

By Neil George, Editor, Profitable Investing

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Source: Rick Tap via Flickr

The inverted yield curve. This phrase is quickly spreading around the financial media as a forthcoming of doom for the stock market and the economy.

This is a stretch. But perhaps it’s gaining traction because we’re all becoming more in need of headline grabbers and hyperbole to get our attention. But let me walk you through what’s really underway in the U.S. Treasury market and what it means and what it doesn’t mean for your stock portfolio.

I’ll start with the fact that the Treasury market isn’t inverted. An inversion is when short-term yields are higher than long-term yields. Now some are citing that this week saw the five-year yield dip below the three-year yield. But by traditional measurements, an inversion is when the ten-year drops below the two-year and we aren’t there.

Here’s the current market for the U.S. Treasury market. The one-month bills are yielding 2.41% and the two-year is at 2.69%. Rolling out to the ten-year finds the yield at 2.91% and the thirty-year is at 3.17%.

Source: Bloomberg

US Treasury (Actives) Yield Curve

This is not an inverted curve but is, of course, flatter from the two-year on out on the curve.

But what is also worth looking at is how the market has moved over the past twelve months. The yield for the two-year has gone from 1.82% to 2.80%, generating a return of 1.00%. The five-year went from 2.14% to 2.81% generating a loss of 0.30%. And the ten-year went from 2.35% to 2.92% for a loss of 1.90%. And finally, the thirty-year went from 2.73% to 3.17% for a loss of 5.40%.

Source: Bloomberg

US Treasury (Actives) Yield Curve 12M Shift & Returns

That’s all behind us. So, where does this point us going forward?

Inversion Means

If and when the yield curve does move to an inverted state it won’t act to cause stocks to fall. There is no causality between the Treasury curve and the S&P 500 Index. But an inversion means that the buyers of Treasuries are anticipating the potential for further declines in longer-term yields. And to lock in yield now they’re investing in the hope that yields fall generating price gains. And since the longer the maturity, the greater the price movement for an equivalent yield drop will mean greater returns.

Yield, of course, is driven by expectations for inflation, credit and the overall supply and demand for Treasuries. Inflation, of course, is still low and shows little indication of rearing up for the coming quarters. The best measurement of inflation remains the personal consumption expenditure index (PCE). It is currently at 1.77% for the most recent month down from a brief blip up to 2.02% in July. And while it is above the five-year average of 1.59% – it is just barely above the two-year average of 1.74%.

Credit of the U.S. Treasury remain at or near the top tier of the globe’s governments. And while many question that — citing deficits and a lack of discipline by leadership over longer-term budgets – the globe’s big buyers continue to buy and own Treasuries as the core of their portfolios and capital bases.

Supply and demand are where we can see some issues. The U.S. Treasury began to increase issuance this year on the back of the Tax Cuts and Jobs Act (TCJA) of 2017. The changes in revenues meant that issuance had to be upped. And the Treasury focused particularly on shorter-term maturities – which upped supplies.

Meanwhile, demand has had challenges from other parts of the bond market. Corporate bonds with higher yields and expectations for rising revenues on a strong and expanding economy along with lower tax obligations make for better buys.

And municipal bonds also have had better market opportunities with better state and local revenues driving the market to better opportunities.

So shorter-term yields for Treasuries crept up more than longer-term yields bringing us to the current market show above.

The key is that inversion tends to be viewed as an indicator of a slowing economy and in turn a slowing in inflation. This in turn would mean that the companies behind the stocks in the S&P 500 Index would be expected to see lower revenues and lower profits. But right now, while there’s indications for less robust growth for 2019 than for 2018 – there’s little to show the way for recession over growth.

And while profits for the bulk of the companies with stocks in the S&P 500 may slow in their rate of growth – there is little to argue that the growth will be reversed into losses.

For the inversion to mean something of doom, we would need to also see a slowing in consumer spending and business investment. And we would have to see the broader credit markets contract slowing the funding for company expansion. Right now, there’s less indicating that this is in the works on a broader basis.

Instead, look past the rhetoric and focus on the companies and market sectors that are still working and delivering dividends and returns for their investors.

Neil George is the editor of Profitable Investing and does not have any holdings in the securities mentioned above.


Article printed from InvestorPlace Media, https://investorplace.com/2018/12/should-you-care-inverted-yield-curve/.

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