Why investors near retirement should fear the big yield curve inversion

  • The yield curve between the two-year Treasury and five-year Treasury inverted on Tuesday.
  • The inversion rattled investors, as it typically has been a harbinger of recession.
  • The big Treasury-rate inversion, between the two-year and 10-year, hasn't happened yet, but it looks close and would have a ripple effect through the U.S. economy.

For sophisticated bond market investors, no three words invoke more fear and debate than "inverted yield curve." Yet many individual investors don't understand inversion and why a healthy fixed-income market is so critical to their financial well-being.

With the near-800-point drop in the Dow on Tuesday being at least partially attributed to the sudden inversion of short- and longer-term Treasury yields, it is time to take notice.

Traders signal offers in the Ten-Year Treasury Note Options pit at the Chicago Board of Trade.
Scott Olson | Getty Images
Traders signal offers in the Ten-Year Treasury Note Options pit at the Chicago Board of Trade.

It shouldn't have taken this long: Articles about the risk of an inverted yield curve have been all over the place in the past year, and the overwhelming majority of those stories painted a pretty dire picture for the economy. On Tuesday bond king Jeff Gundlach of DoubleLine Capital stated it simply: The yield curve inversion means the economy is poised to weaken.

Should you be concerned? You should be concerned enough to make sure you understand what it is.

So here is a quick summary:

Start with a government-issued two-yearTreasury bond and a 10-year Treasury bond. They both pay interest. Typically, the 10-year pays a higher interest rate than the two-year to compensate buyers for the time difference. The difference between the interest rates in these two bonds is called the "spread." If the spread is greater than zero, it means the two-year interest rate is lower than the 10-year, and that is normally the case.

A normal spread for these two bonds will take the appearance of a rising chart — an upward-sloping yield curve. But when the spread goes negative, theyield curve "inverts," giving the appearance of a negative yield curve. That may sound technical, the kind of market jargon that is for "chart traders." However, this negative yield curve is huge for all investors, because it is connected to the risk of recession.

Why the banks tanked, and why that matters

A normal curve with the two-year offering a lower yield than the 10-year is fundamental to how banks make money. Banks borrow short term at lower interest rates so that they can make long-term loans to borrowers at higher interest rates. The difference between those two interest rates, the positive spread, is their profit. If a bank is borrowing short term at a higher interest rate and making loans to borrowers at a lower interest rate, the difference is a negative spread.

In this interest-rate environment, banks would lose money by making loans. Not necessarily on all loans, but it does make some loans unfeasible and some less profitable, forcing banks to cut back on making loans, thereby choking off the access to credit markets that businesses need to grow.

This helps explain why bank stocks entered a correction on Tuesday. But the news is bad for all businesses.

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When it becomes harder for businesses to borrow, many companies cancel or delay projects and hiring. Weaker enterprises go out of business because they lose access to credit, which in turn causes layoffs. When this happens, it takes about a year, on average, for the U.S. economy to slip into a recession.

Many market pundits say that the history lessons from a flattening or negative yield curve is not relevant in today's world of massive central bank intervention, encouraging foreign investors to scoop up long-term U.S. treasuries because their home-country government bond yields are much lower.

But to believe that "it's different this time" means you'd have to believe that the bank-sector math in the above example stopped working. Last I checked, banks still borrow at short-term rates and lend at long-term rates, as long as it is profitable. In other words, central bank-induced market distortions do not change the basics of the banker's math I described above.

There are a few important caveats: In a longer-range chart going back to 1962, there has never been a recession that wasn't preceded by an inversion of the yield curve. Yet it doesn't happen overnight. In fact, stocks have risen in the 18 months after an inversion, though after that all bets are off. Also important: This is a market stat that specifically refers to an inversion between the two-year Treasury and 10-year Treasury bond.

It looks more like that is going to occur, but it still has not happened. On Tuesday the 10-year was at 2.9 percent, still above short-term rates, if not by much — the two-year was at 2.8 percent. On Tuesday it was the five-year Treasury that slipped below the two-year and three-year bonds. In the last three recessions, the curve of the three-year and five-year had inverted an average 26.3 months before the recession.

3 steps that could stop the inversion

There is still a risk of the big inversion. I would say we are perilously close. What could stop the collision course between the two-year and 10-year rates? Three things:

1. The Federal Reserve could stop raising short-term rates. Fed chairman Jerome Powell sounded more dovish in his comments last week, saying rates are close to a range of neutral estimates, comments that pushed the market higher on the belief the Fed would not raise as often as the market had been baking into its outlook. DoubleLine's Gundlach said on Tuesday the inversion makes clear that the amount of rate hikes the market thought were coming are not.

President Donald Trump, who has been vocal in his criticisms of Powell and the Fed's plans to raise rates, was apparently happy with Powell's speech, according to comments from Treasury Secretary Steven Mnuchin. And Trump has not been the only prominent figure questioning the Fed's stance, with aformer Dallas Fed vice president calling it "very aggressive" earlier this year. Fed Vice Chairman Richard Clarida told CNBC last week the Fed is "much closer" to neutral.

2. Investors could lose their appetite for holding on to their existing supply of Treasurys. It seemed like this was starting to happen last February, but that moment came and went, sending the 10-year back below 3 percent. On Tuesday the 10-year was at 2.9 percent after having reached 3.2 percent earlier this month.

3. The Fed could unload a bunch of Treasury securities from its balance sheet. This is controversial, because once it happens, investors will lose faith in the Fed's ability to stop doing it, which would send long-term interest rates substantially higher. Plus, investor expectations that the Fed would go very slow in unwinding its massive balance sheet are such that it would take a massive hit to its credibility.

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This is financial markets' "inside baseball," but yield-curve analysis is as important to individual investors saving for retirement as it is to large institutions, if in different ways. These two types of investors have investment objectives that are different and that need to be distinguished.

Controlling your own risk of market complacency

An institutional investor, like a large pension or endowment plan, is aiming for a certain and consistent risk-adjusted return in order to pay out pensioners a promised amount over their lifetimes. Short-term volatility in its returns is something that the pension manager is trying to smooth out. So the debate unfolding in the media about the yield curve and between multibillion-dollar portfolio managers is getting pretty intense. They may be under pressure to make big adjustments to their portfolios.

For the individual retail investor, the goals are different. It must be an acceptable risk that recessions — and the bear markets that are associated with them — will happen many times over the course of one's lifetime. This is exactly why risk tolerance needs to be adjusted lower as one ages. Your investment portfolio should take into account how many working years you have left, if any, and you should adjust yourasset allocation.

I wouldn't use the moment of an inversion as a retirement-planning tool, and most investors do not need to worry about market timing. It is about thinking internally about the "what ifs" of bear markets and if one has the risk tolerance and time horizon to ride one out. That's the most important point in all of this for regular, everyday investors.

You can't control whether or not the yield curve inverts; all you can do is control your own potential for market complacency. We have had multiple gut checks in 2018, and this is just one more. Last February stocks got slammed and investors were nervous when talk of the yield inversion first came into focus. Now it is happening again. And Wall Street is becoming more sober with return expectations.

Goldman Sachs said this week it expects cash to be the best-performing asset next year and it expects low returns for just about everything. Take it as a reminder that when markets change direction, they can do it fast. Don't just rebalance as a function of the gains particular sectors have made; do it also according to age and the fact that you and many other investors are 10 years older since the Great Recession.

By Mitch Goldberg, president of investment advisory firm ClientFirst Strategy

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