The financial theme in 2019 has been the inverted yield curve. Why is it so important…it’s only predicted the 5 or 6 recessions, meaning it has given no false signals going back 50 years. Another signal of a pending recession came last week when the US purchasing-managers index contracted to 49.9 in August from 50.4 in July, the first such shrinkage in almost 10 years.
The discussion of inverted yield curves is so important that I decided to repost my post on the topic from more than a year ago…withouth further ado.
A bond is like an IOU given to you by a bank. When you lend the bank money, they’ll give you back that same amount at a later time along with a fixed amount of interest. For example, if you bought a two-year bond for $100 with a 2% annual return on it, you get $104.04 back after two years. Bonds have a number of benefits that justify the small rate of return. Government bonds are stable investments and bonds issued by the US government have never defaulted…YET.
The term yield curve refers to the relationship between the short- and long-term interest rates of fixed-income securities issued by the U.S. Treasury. Typically, short-term interest rates are lower than long-term rates reflecting higher yields for longer-term investments due to the higher risks associated with long dated maturities. Also, in a growing economy, investors demand higher yields at the long end of the curve to compensate for the opportunity cost of investing in bonds versus other asset classes.
As the economic cycle begins to slow, the upward slope of the yield curve tends to flatten as short-term rates increase and longer yields stay stable or decline slightly. As concerns of an impending recession increase, investors tend to buy long Treasury bonds as a safe harbor from falling equities markets. As more and more investors begin to buy long-term bonds, the Federal Reserve lowers the yield rates. Since investors aren’t buying a lot of short-term U.S. Treasury bonds, the Fed will make those yields higher to attract them. Eventually, the yield on short-term bills rises higher than the yield on long-term bonds, and the yield curve inverts.
The inverted yield curve is the single greatest indicator of a coming bear market. The inverted yield curve has predicted the past 5 recessions going back to the late 1970’s. Every time the yield curve turns negative, a recession has occurred in the near future. Since 1956, equities have peaked six times after the start of an inversion in the yield curve and the economy has fallen into recession within seven to 24 months.
The most recent inverted yield curve first appeared in August 2006, as the Fed raised short-term interest rates in response to overheating equity, real estate and mortgage markets. The inversion of the yield curve preceded the peak of the S& P 500 in October 2007 by 14 months and the official start of the recession in December 2007 by 16 months, eventually leading to the Great Recession in which the S&P 500 dropped 50%.
This next inversion is upon us right now. Based on history, I’m predicting the yield curve will invert by the end of the year, the Markets will peak in 2019 and we will be in a recession in 2020 (a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters).
However, this time around balance sheets of the Fed and Treasury extremely over leveraged right from the start. Our national debt over $20 trillion dollars and the Fed’s balance sheet at $4.5 trillion. Thus, when the yield curve inverts for the third time this century, you can expect unprecedented chaos in markets and the economy to follow shortly after because the yield curve will not only invert at a much lower starting point than at any other time in history. This represents a huge opportunity for those that can identify these inflection points and know where to invest. Be sure I will be here to tell you those opportunities and how to protect your capital.
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This post is my personal opinion. I’m not a financial advisor, this isn’t financial advise. Do your own research before making investment decisions.