Beware: The Inverted Yield Curve

Once of you guys, it's Graham here. So every now and then, I like to deviate a bit from real estate and personal finance to discuss some other topics of importance, and this is one of them. That would be the inverted yield curve, and this is a topic that's been coming up a lot lately—like a lot, a lot. So what's the big deal, and why are so many people freaking out over this?

Well, the answer to that is that according to economists, an inverted yield curve is really seen as a prediction for an upcoming recession. And guess what just happened? On Friday, we should cue some really spooky music here because the yield curve, it just inverted. So let's talk about exactly what this is and how this works in very simple terms, why this is worth paying attention to, and what this means for the economy going forward.

If this means that our entire society is doomed to collapse unless you hit that like button—because just gently tapping that like button is a solution to every single problem that solves everything if you just hit the like button. Thank you very much, and let's get into the video.

Okay, so let's start here: what is the yield curve? I will do my best to simplify this as best as I can. The yield curve pretty much just graphs the short-term bond returns with the long-term bond returns. If you're confused with what a bond is, just basically think of it like an IOU that promises you a certain return within a certain time frame.

Generally speaking, the longer you lend your money out for, the higher the return you should get. This is because long-term, you aren't really sure where the markets are heading, you're not sure what policies might be like in ten years from now, and you're not sure what inflation might be like. So in a sense, there's almost more to go wrong.

Because of that, you should be compensated a little bit more the longer you invest. Of course, the shorter the term that you invest in, the lower the return you should get because you're taking on less risk, and also because you're not tying up your money for such a long amount of time.

However, with that said, right now, things are actually quite the opposite. You can actually get a higher return investing in US bonds for three months than you can investing in US bonds over ten years. This is what's called the yield curve inverting. This signals that investors see more risk investing in the short-term than they do investing in the long-term, so they're going and buying long-term bonds to basically lock in a guaranteed return.

When investors go and buy all of these long-term bonds, they drive up the prices of those bonds and basically lower the overall return that bond will generate. Now that just leaves way less demand for the short-term bonds, which then have to increase their rate of return just to incentivize investors to go and buy them.

Now hopefully, my amazing explanation made some sense, but even if you don't understand and you don't get it, that's fine. All you really need to understand is just this: that typically, when this happens, it's used as an indicator to predict a recession is soon to come.

Looking back all the way to the 1960s—and I'll throw a graph up on the screen so you can follow along with what I'm talking about right here—but basically, when the three-month 10-year yield inverted for more than 10 days, it took on average about 311 days from there to actually enter a recession. And of course, fun fact of the day: when you do enter a recession, it will last on average of 17.5 months.

Now at this point, I think it's really important that we put all of this into perspective and we look back the last 40 years to see what's happened. In May of 1989, the yield curve inverted, and at that time, the S&P 500 was trading around $300. But wait, because over a year later, after the yield curve inverted in July of 1990, the S&P 500 continued going higher and hit a high of $370. That is 23 percent higher in 14 months after the yield curve inverted.

Okay then, but by September of 1990, this was 16 months after the yield curve inverted; the S&P 500 had fallen to a low of $295, which was a 20% decline from the recent peak. Given all of the volatility, this really only meant that the market dropped 2% over 16 months from the day the yield curve inverted, which really isn't that bad when you put it in perspective.

The actual recession itself lasted just about six months because by March of 1990, we were back to an S&P 500 value of $370. Yield curve crisis averted! Then we have the next one in 1998, where the yield curve barely inverted. The S&P 500 at that time dropped from $1,133 to $957, which is a fifteen percent decline. But within just three months, it regained all of those losses plus started going up even higher with plenty of profit.

The next yield curve inversion was in 2000. Prices hit their peak in August of 2000 at $1,517. Then we saw a two-year drop all the way down to $815 as the dot-com bubble burst. But the actual recession itself only lasted from March 2001 to November 2001.

Then we have February of 2006, where the yield curve inverts again. At that time, the S&P 500 was trading at $1,217. So even though the yield curve was inverted, by October of 2007—this was twenty months after the yield curve had inverted—the S&P 500 had risen and was trading for $1,550, which was a 27% increase.

Now, of course, it was after this where it dipped to a low of $734 in February of 2009 as the banks collapsed from subprime loans and a multitude of other screw-ups. But by June of 2009, the recession was over, and a recovery was already underway.

And of course, now, like I said, here we are again, and the yield curve is inverted. So here's what this means, and here's what you should do about it. Basically, an inverted yield curve just means that investors are pessimistic about the short-term outlook for the United States economy.

The inverted yield curve is more like a symptom of an underlying problem of investor expectation rather than the problem itself. The interesting note with us, though, is that now that we're aware of the inverted yield curve and try to predict a recession from it, will we cause this to now just become self-fulfilling? Or is this already factored into current prices because we now soon expect it to happen?

Now, fun fact: in physics, this is actually what's known as the observer effect because the mere act of observing something or being aware of it diminishes its power and accuracy, because you can now act on those signals.

So in essence, getting a proper read and prediction on what's going to happen with the inverted yield curve is a bit like taking a shot in the dark. Yes, this has predicted the last nine recessions with one false positive, but this doesn't always mean it will be the case with 100% certainty.

And if it is right, we still don't know how the market will behave and where the market will end its highs and lows. A recession could happen now, or it could happen a year from now. The markets could go up another fifteen percent before they decline, or they can go down 10 percent tomorrow. No one can predict it, and most of the data that we get is really analyzed after it's already happened.

So we can't be completely sure what will happen in the near future to act on it with any sort of reasonable accuracy. This really leads me to my own thoughts and my own advice, and this is basically how I run my entire life: focus on the things you can directly control and ignore all the things you can't.

Like, here's what you can't control: what the stock prices will be a year from now, when a recession will happen, how long a recession will occur for, when will be the top of the market, when will be the bottom of the market, what is going to happen with the US economy in the short term, and whether or not I asked you to smash that like button if you haven't done that already.

On the other hand, here are the things you can directly control: whether or not you actually smash that like button, whether or not you pay down any high-interest rate debt you might have, whether or not you keep a six-month emergency fund, whether or not you live below your means, whether or not you invest consistently long-term, and whether or not you're over-leveraged in whatever investments you make.

See, by focusing on what you can control and then disregarding everything you can't control, you give yourself much greater power to make the most of opportunities long-term without concerning yourself about what the markets may or may not do in the short term.

Like, if the markets go down, that's fine; it's just part of the normal market cycle. Use that as an opportunity to continue buying at lower prices knowing that long-term you'll be okay. If the markets continue going up, then that's fine too; that just means that your current investments are also going up in price, and you're making money.

Of course, you know that at some points they can and will go down in price, and that's just perfectly normal. So don't ever be shocked if something you buy falls in value; don't ever panic and think that you're doomed. It's just par for the course.

But just rest assured that if you keep holding and you keep investing, you'll come out ahead in the long term. And that's pretty much this: what I'm doing. I just make sure I'm not over-leveraged; I have no variable interest rate debt, I have no short-term loans, I live drastically below my means, I keep a very large emergency fund in case anything happens, and then of course, I just keep investing as normal.

Sometimes I'll buy highs, sometimes I'll buy low, but I don't concern myself with what I cannot control. I just continue investing long-term, and of course, when it comes to the inverted yield curve, I just suggest you do the same.

It's great to be aware of economics and of course what drives business, but at the end of the day, focus on what you can control and make sure you're not in a position where you'll be hurt if prices fall so that you can just ride it out until whenever it recovers.

Also, understand that even in a recession, even when prices drop—because they will at some point—that those are often the best opportunities to take advantage of. It should really be something to embrace; it should not be something to fear.

So with that said, you guys, thank you so much for watching. I really appreciate it. If you made it to the very end and you haven't already subscribed yet, you should! You should very much subscribe—it's totally free. All you gotta do is destroy that subscribe button and then go right next to it, destroy that notification bell so it notifies you anytime I post a video.

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