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Understanding the “Inverted Yield Curve”

The stock market fell on the 22nd of March after the bond market experienced what’s known as a “yield curve inversion.” Essentially, the 3-month Treasury bill rate is now higher than the 10-year Treasury bond rate. This phenomenon – where bonds investors demand higher interest rates for short term lending than for longer term lending — has garnered attention because it occurred before all seven of the previous recessions going back 50 years. Once, in September 1998, the yield curve inverted and no recession materialized. A recession typically occurred one year after the yield curve inverted, with a range of 5 to 17 months.

The fall in long term rates was precipitated by a number of factors. Earlier in the week, the Federal Reserve reversed course on anticipated rate hikes – going from two expected hikes this year to zero. Accordingly, current bond yields became suddenly more attractive, driving investors to purchase more Treasury bonds and drive down yields.

Then, on Friday, German manufacturing data came in much worse than anticipated, indicating that the recent manufacturing slump was getting worse. That in turn pushed rates on German bonds lower – all the way into negative territory for 10 year bonds – the first time since 2016.

In light of these developments, the question becomes whether an inverted yield curve is signaling that a new recession is around the corner.

While it is true an inverted yield curve has been a good predictor of recession, it’s important to understand why. Typically the yield curve inverts when inflation is rising and the Fed is forced to raise rates aggressively. Eventually the Fed raises rates too far, which increases the cost of borrowing and hurts the economy.

This does not describe the economy today, in our opinion. Inflation is very low and the Fed has been timid in raising rates. It is easy for borrowers to obtain financing.

It is more likely, in our view, that interest rates reflect extraordinary actions by central banks around the world. Rates are negative in Japan and parts of Europe.  The Fed also is a huge owner of Treasury bonds and announced a related policy change last week that likely caused rates to fall.

Meanwhile, economic data continues to be solid. For this reason, we caution investors from overreacting to the news of an inverted curve.

Lastly, though we do not expect a recession over the near-term, remember that economic downturns are inevitable.  Hefren-Tillotson financial advisors work with you to construct a portfolio aimed at seeing you through the economy’s ups and downs.

DISCLAIMER: Past performance does not predict future results. This report is based on data obtained from sources we believe to be reliable. Hefren-Tillotson does not, nor any other party, guarantee the accuracy or completeness of this report or make any warranties regarding results obtained from its usage. All opinions and estimates included in this report constitute the firms judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation to buy or sell the securities herein mentioned.

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