April 25, 2022
Q. Are we headed for a recession? I’ve heard that the yield curve recently inverted and is that a signal that we are headed for a recession?
Before that question is answered, I’d like to explain what an inverted yield curve is.
A bond is debt, plain and simple. It’s like your mortgage in a way. The longer you hold the mortgage, generally, the higher the interest rate. This is true of Corporate and Government debt as well.
There are a couple of terms that get confusing when we talk about bonds:
Rate (Coupon) - This is the stated rate of interest. Let’s say you buy a bond ($1,000) at 4%. You can expect to receive $40 per year until the bond matures.
Price - Bonds fluctuate in price. If you are holding that 4% bond and interest rates go up, and you want to sell that bond, you will have to offer a “discount” to attract a buyer. If someone can get a 4.5% bond, they wouldn’t offer you full price for a 4% bond.
Yield - this is where it gets confusing. If, as mentioned above, someone buys your 4% bond, at a discount (say $900 for easy math), then their yield is 4.44% ($40/$900). So they got it cheaper than the original price, but still not as attractive as the “new” bonds being issued.
Spread - the difference between short-term and long-term yields.
In a “normal” yield curve, long-term interest rates are larger than short term interest rates.
In an inverted yield curve, short term interest rates are larger than long term.
This chart found on Inverted Yield Curve: Definition, History & Impact | Seeking Alpha does a good job of showing how this all interacts:
So now to your question: Yes, an inverted yield curve can be one of the signals that we are headed for a recession. But it rarely happens immediately, and there are other factors that should be considered.
We follow a number of economic factors. This chart, produced by Franklin Templeton shows multiple factors and various historically economic recessions. We believe it is important to look at all the facts, not just the “breaking news.”
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