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Market Conditions: Bond Market Breakdown

Market Conditions: :Bond Market Breakdown

Headline grabbing news occurred on March 22nd when yields on 3 mo. (short-term) treasury bills were quoted as higher than yields on 10 yr. (long-term) treasury bonds. This yield structure (called an inverted yield curve) is not just abnormal, it has preceded almost every recessionary period since 1950! Thus, begging the question…are we headed towards a recession?

 

The Yield Curve.

There is a lot that goes into the relationship between bond prices and yields, but for purposes of this article you need to know 2 key things:

1. Normally, longer-term bonds have higher yields than shorter-term bills. This is to incentivize investors to lend their money for a longer period of time.

2. The opposite occurred during the last week of March. Shorter-term bonds were yielding more than longer-term bonds.

To illustrate the difference between a normal curve (orange) and an inverted one (blue), the graph below compares the yield curve on March 22nd this year vs. last year. Notice that yields quoted in orange slowly trend upward as the length of the bond increases. Now notice that one year later the yields quoted in blue show higher short-term yields and lower long-term yields.

Inverted Yield Curve Chart
Source: U.S. Department of the Treasury

How we got here.

The current yield curve shows that investors are willing to pay higher prices for longer-term bonds, WITHOUT the benefits of a higher yield…but why?

One theory is that investors fearing an economic downturn have driven up the prices of longer-term bonds. These investors believe that current long-term bonds represent better value than future bonds because they are anticipating a recession. If a recession is imminent, this is a good strategy. However, if a recession does not occur then the investor would has more to lock-in a long-term bond with an inferior yield. Yikes!

Is a recession imminent?

The short answer is…no one knows!

The Federal Reserve Bank of Cleveland (FRBC), which is one of 12 reserve banks that execute monetary policy decisions, recently released an overview of the yield curve figures and their impact on both GDP growth and the probability of a recession.

While the FRBC indicates that the probability of a recession increases with an inverted yield curve, like we saw at the end of March, they caution against using the curve as an absolute indicator. The FRBC notes that there have been two flat/inverted curves in the past that have not led to recessionary periods. Additionally, markets are constantly evolving, and it is difficult to gauge whether the yield curve’s statistical relationship with future economic output will hold.

In this context, while an inverted yield curve does provide helpful data, it is only a piece of the puzzle. An investment recommendation should be aligned with a client’s financial, tax and estate planning goals while accounting for risk tolerance.

 

Sources:

https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield

https://www.clevelandfed.org/our-research/indicators-and-data/yield-curve-and-gdp-growth.aspx

 

About the Author: Taylor WhelanABOUT THE AUTHOR

Taylor J. Whelan is a CERTIFIED FINANCIAL PLANNER™ Practitioner, Chief Compliance Officer and a Wealth Advisor at Whelan Financial. When Taylor isn’t meeting with his own clients, he is instrumental in business development, conducting investment research, and advancing the company’s technology.

Follow him on LinkedIn @TaylorWhelan

 

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