Given the recent talk of market downturn, many might be wondering what exactly an inverted yield curve means. To the right is an example of a Yield Curve Inversion. Read on to find out exactly what it entails, and how it could effect your retirement.
What is yield?
Yield is a measurement of cashflow for a given maturity period. In the case of bonds/notes, like treasury securities in the chart to the right, you take the realized return of the coupon payments on the bond over the principal value of the bond.
Why do yields matter?
Because yields are calculated over the principal value of the investment, they move in the opposite direction of bond prices. In market downturns, investors look for shelter in conservative investments like bonds. Prices on those bonds then rise according to demand, yields fall correspondingly – and vice versa. This means that yields are a handy barometer for investor sentiment about where the market may be heading.
Why does an inverted yield curve matter?
For clarity, the yield curve we’re talking about is the curve of the difference between the 10yr and 2 yr treasury yields. On the chart above, that would mean subtracting the value of the purple line from the orange line and graphing the result. Inverted means that the resulting number is negative, as is the case in the highlighted portion.
If we accept the yield curve as a rough approximation of market sentiment for the period of the yield, we’d expect the longer term yield to be higher than the short term; we generally expect the market over the long term to perform positively and trend higher. The exception is when troubled times are expected ahead. This inversion indicates that investors expect outcomes in the longer term to be poorer than the near term.
Historically, an inversion of the 10-2yr treasury yield curve has been one of the most reliable indicators of a coming recession or market downturn.
Does this guarantee a recession?
Definitely not. An inverted yield curve, while a troubling signal, is just a signal. It’s a correlation, not causal. Concerned retirement plan participants should seek out their plan’s financial advisor for deeper conversations about how they’re invested and whether they should be reallocating.
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