This has been a busy week for the many pundits on Wall Street. Last week was a volatile week in the markets that many attributed to the ongoing trade war with China. Wednesday though, we saw the U.S. markets fall by nearly 3%, which was primarily due to the U.S. Treasury yield curve temporarily inverting.
What is a yield curve, and why are stock investors interested in its shape?
A yield curve gives a snapshot of how yields vary across bonds of similar credit quality, but different maturities, at a specific point in time. For example, the U.S. Treasury yield curve indicates the yields of U.S. Treasury bonds across a range of maturities. Bond yields change as markets digest news and events around the world, which also causes yield curves to move and change shape over time.
Historically, yield curves have mostly been upwardly sloping (short-term rates lower than long-term rates), but there have also been several periods when the yield curve has either been flat or inverted. When the yield curve inverts, it has historically been a good indicator that a recession is coming. The chart below shows the difference between the 10-year Treasury yield and the 2-year Treasury yield. The gray bars shown represent recessions. What we can see in the chart is that when the spread between the 10-year and 2-year yields turns negative, a recession generally follows.
We can see from the chart above that the slope of the spread has been downward since 2014. What occurred Wednesday, is that during the trading day it turned negative. While it closed the day positive again at 0.01%, the markets took at as an indication of a future recession, causing dramatic downturns in the financial markets. Why does the idea of a recession cause this though? For investors, a recession typically means a decline in earnings. With the value of stocks being largely based on the expected future earnings, when those expected earnings are reduced, the stock becomes less valuable.
What to do if we assume the indicator is correct and a recession is coming?
While we can see from the previous chart that a yield curve inversion is a good indication of a future recession, it is not perfect. First, it doesn’t tell us exactly when a recession will occur. In fact, the time between an inversion and a recession actually beginning, has ranged from 18 months to almost 36 months. Second, it does not indicate the depth of the recession, or how long the recession will last. Third, it provides no indication as to how the stock market will react. While generally a recession leads to declines in the stock market, when those declines are experienced and how long the market takes to recover, are different with each recession.
If an investor believes that a coming recession will lead to a decline in their stock portfolio, wouldn’t they want to sell their stocks? The problem with this, is that to time the recession correctly, the investor needs to be able to predict when the market’s decline will start and when it reaches its bottom. Historically, most investors are reactive and trade on emotion. This results in them starting to sell after the decline has already begun and then not buying back in until the market has fully recovered. Effectively they have sold low and bought high, which is the opposite of what should be done when investing.
So, what can investors do if they are concerned about potential downturns in the event a recession occurs? A good starting point is focus on the things they can control. First, is to create an investment plan to fit their risk tolerance, income needs, and the long-term returns needed for their financial plan. Next, is to implement that plan by building a globally diversified portfolio. They should then focus on remaining disciplined to their investment strategy and manage their emotions. Many investors struggle to separate their emotions from investing, leading to poor investment decisions. Having a well thought out investment plan, diversifying globally and staying disciplined through market dips and swings can lead to a better investment experience.