For those invested in securities, the last few years have offered thrilling milestones, as the closing bell on so many trading days has ended with one record-shattering day after another.* If those market indexes were all we considered when predicting the future, we could be forgiven if we saw nothing but clear sailing ahead.
But there's another trend, this one sending tremors of worry through the bond markets, that demands attention because it suggests another downturn may be on the horizon.
In the bond market, it's called an "inverted yield curve," and this wonky-sounding event has presaged every recession for the last 60 years. Only the timing of the downturn is in question, with recessions showing up somewhere between 6 to 24 months after the inverted begins.
Before we explain what the inverted yield curve is and why it's worrisome, let's set the stage with some basics about bond markets.
Bonds are instruments of debt issued by corporations, cities, and governments, such as our federal government, whenever they need to raise money. When investors buy bonds, they expect to be repaid in full at a later date with interest based on the risk associated with the bond.
Sometimes the risk is considerable. Remember the junk bond crisis of the late 1980s, early '90s? Back then, lots of businesses on shaky footing tried to borrow themselves into profitability by issuing "junk" bonds that paid bond holders a high rate of return commensurate with the risky nature of the investment. Unfortunately, lots of those junk bonds weren't worth the paper they were written on, and the financial services industry was indelibly transformed by the fiasco that followed.
But for conservative investors, there can often be nothing more comforting than bonds. Typically one of the safest bets around, these bonds offer investors an assured rate of return on their money for very little risk. US Treasury bonds, or T-Bills, are considered the safest in the world, thanks to their backing by the U.S. government.
There's nothing terribly exciting about how government bonds work:
You buy a bond - or coupon in the parlance of the bond market - and essentially park your money for a fixed period of time - or it's "maturity date." In return, the issuer promises to pay you back in full at the end of that period plus a pre-determined rate of interest - called the "yield."
In theory, the shorter the duration of the coupon, the lower the yield, while longer term coupons offer higher yields. That's because there's a greater risk that unforeseen events such as rising inflation or economic downturns will erode your yield over those longer periods than shorter ones. So, the higher yields on long-term bonds - those with terms of ten years or more - are meant to compensate you for the added risk. If you plotted these yields in a chart, you'd see a rising curve with yields ascending over time.
That is, until now.
For the last few months, long-term T-Bills have actually offered lower yields than short-term ones. As of July 26, for example, a 4-week T-Bill offered a yield of 2.13 percent, while a 52-week T-Bill's yield was just 2.00 percent. And it isn't just U.S. Treasury bills and other U.S. entities which have begun paying less for longer term bonds: it's a trend taking place throughout the world as nations as diverse as Japan, Germany, Sweden, the UK, and dozens of others are all lowering their bond yields over the long-term.
The Big Question: Why?
When pricing yields, economists have to take into consideration lots of factors. But few are as critical to pricing as interest rates, both current rates and the best forecasts for the future.
As you might imagine, fluctuating interest rates pose a big problem for bonds. When interest rates are expected to rise in the future, bond-issuers have to offer higher yields on long-term bonds to entice buyers away from other investments. That makes bonds more expensive for the issuer, while making bonds more attractive to investors.
On the other hand, when interest rates are expected to fall in the future, issuers don't want to be caught overpaying for their bonds, so they lower rates. That might make borrowing money cheaper for the issuer, but it also makes the bonds less attractive to buyers.
Why Interest Rates Rise and Fall
So far, we've been talking about fluctuating interest rates as if they were only a supporting player in this scenario, when in fact, they are actually the lead actor. The reason that the inverted yield curve is alarming to so many observers is that it points to expectations for falling interest rates in the future. And that is often a harbinger of economic troubles.
Here are just some of the factors on the horizon that point to the potential for an economic downturn and the reason for this inverted yield curve:
* The Fed has signaled lower interest rates later this year, despite earlier statements that it would be raising interest rates throughout 2019. This new course of action is widely being interpreted as a sign of a cooling economy.
* Second quarter GDP was a sluggish 2.1 percent, another possible indicator of an anemic economy.
* The economic "cold war" that seems to be gaining steam between the U.S. and China holds the potential for all kinds of negative financial impacts.
* Brexit and other economic indicators in Europe are signaling possible downturns in the economies of many of our trading partners.
* Growing trouble in the Middle East, especially the straights of Hormuz where Iran has become especially aggressive in attacking the oil tankers of other nations, could flare up into a serious international conflict that impacts the flow of trade, most particularly, oil.
Now What?
Usually, what's bad for bonds is good for stocks, and we've certainly seen investors shun bonds in favor of equities lately. But an ebbing tide can ground all boats, so in a full out recession, even stocks may be affected. That's why your money manager should always keep a vigilant eye on economic trends and remains ready to respond accordingly as market conditions require.
