This Poses a Bigger Threat to Stocks Than Trade Wars
An inverted yield curve is "a powerful signal of recessions."
— John Williams, New York Federal Reserve President
There is no shortage of things for investors to worry about. Tariffs, trade wars, rising oil prices, widespread social unrest, stretched valuations and, of course, this very old bull market.
However, the one thing that should worry you most is how perilously close the yield curve is to inverting.
That's because the yield curve has an uncannily accurate track record of forecasting recessions. Fact: There have been nine recessions in the last 60 years, and EVERY one of them has been preceded by an inverted yield curve.
The yield curve is the difference between interest rates on short-term government bonds (the two-year Treasury note) and long-term government bonds (the 10-year Treasury bond).
Historically, when the economy is strong, interest rates on long-term bonds will be substantially higher than those on short-term bonds. The yield curve will have a steep upward slant.
Conversely, when the economy is getting weaker, the yield difference between long-term and short-term rates becomes quite thin. And during recessions, the yield curve actually inverts. That's when short-term rates are higher than long-term rates.
Where is the yield curve now?
As you know, the Federal Reserve has been regularly raising interest rates — seven times since 2015. But interest rates on long-term bonds have increased at a much slower pace. The result is that the gap — the yield curve — has recently flattened to as low as 28 basis points.
Moreover, the Federal Reserve is widely expected to raise interest rates again — perhaps two or more times — before the end of the year. This should compress the yield curve even more.
It wouldn't surprise me in the least if the Fed, in a typical government-bureaucrat screwup, tightens interest rates too much, too fast.
Heck, even one of the Federal Reserve presidents is worried about the same thing …
"I think there is a risk that we'll go too far, too fast as a committee," warned James Bullard, the president of the St. Louis Fed.
You don't have to look too far back in history to find the Fed shooting itself (and our economy) in the foot. The Fed increased interest rates by 400 basis points (bps) prior to the 1990 bear market … 400 bps running up to the dot-com bubble in 2000 … and by 425 bps in front of the 2008-'09 financial crisis.
That doesn't mean you should flee the stock market the moment the yield curve inverts. The yield curve tends to be a leading indicator, which means it can take a while before it affects the economy and the stock market.
On average, our economy doesn't fall into a recession until 15 months after an inversion. And bear markets arrive 17 months later.
Of course, averages can be misleading. You can drown in a river that averages only 2 inches deep.
But make no mistake: If the yield curve does invert, you better familiarize yourself with capital preservation — not capital accumulation — strategies.