“To every thing there is a season, and a time to every purpose under the heaven” – Ecclesiastes 3. Like our decade-long economic expansion, nothing lasts forever.
Recession is on the tips of many tongues today. Judging from recent increased market volatility, this possibility is being intensely pondered. What’s driving the conversation? The shape of the yield curve.
To begin, the level of interest you pay on a loan clearly depends on how long you intend to borrow money. Borrowing for just a few months? You’ll pay a different interest rate than if you wanted to borrow for a decade or more. The yield curve is simply a graphical representation of the different interest rates you’ll pay relative to the length of the loan.
In a healthy, growing economy the normal shape of the yield curve is upward sloping. Naturally, a shorter-term loan usually costs less than a longer-term loan.
However, the yield curve isn’t at all rigid. Like all things, it changes a little from day to day. Instead, think of the yield curve as more of a wet noodle. It can shift, twist flop and flip; changing its shape as millions of lenders and borrowers negotiate in real-time.
In early October, I was lucky enough to visit Ireland with my brothers. Even more fortunately, my brother-in-law from New Zealand knew how to drive on the “wrong” side of the road and expertly navigate roundabouts. It seems the Irish love their roundabouts as much as they do their beer! So, in the spirit of the Irish, please follow me (slowly) around my very own “yield curve” roundabout.
As you now know, yield curves are all about interest rates. And, of course, interest rates are all about borrowing and lending. Borrowing and lending activity supercharges our economic booms and busts. And, you guessed it, perceived changes in our economy drive investors to act ahead of the pack. So, coming full circle on my roundabout, the yield curve definitely impacts markets.
But why exactly are investors reacting to the yield curve today?
The once healthy-looking upward sloping yield curve has been slowly flattening for quite a while now. However, this past week, some longer-term interest rates are now actually slightly lower than some shorter-term rates. The shape of the curve has actually started to move from flat-looking to downward sloping. In financial lingo, the yield curve appears to be slowly “inverting.”
An inverted yield curve is an unnatural concept that signals a possible change in the economic cycle; from economic boom to bust. As a matter of fact, each of the past seven recessions were preceded by an inverted yield curve. So you see, the yield curve can strike fear in investors.
While we haven’t seen an officially inverted yield curve just yet, go tell that to those who write the computer algorithms that drive markets today. Based on last week’s wild ride, it’s clear the algorithms, unlike my Kiwi brother-in-law, simply aren’t programmed to drive carefully on the yield curve roundabout!
Jason P. Tank, CFA is the owner of Front Street Wealth Management, a purely independent and strictly fee-only firm located in Traverse City. Contact him at (231) 947-3775, by email at Jason@FrontStreet.com and at www.FrontStreet.com