What’s a Yield Curve and Why Does It Matter?

A recession is coming! Maybe.

In short, this is what an inverted yield curve means.

Pretty simple, huh?

You may have seen the countless headlines from financial media outlets over the last few days about how the yield curve briefly inverted on Wednesday. (Oh the horror!)

But what does this mean for your money? And how should you react?

The answer to these questions aren’t as clear. Which is why today, I want to explain this complicated phenomenon as best as I can…

Here’s What an Inverted Yield Curve Means

In a normal environment, lenders typically demand to be paid more to have their money locked up for a longer period of time.

This can be seen at your local bank. Just think about the rate you expect to be compensated for locking into a 2-year CD vs. a 10-year CD.

The reasoning here is that investors need to be compensated for the extra risks involved in lending long-term — for example the borrower’s financial situation worsens, inflation rises more than expected, etc.

But last week, for a brief period on Wednesday, long-term lenders were actually compensated less than short-term lenders!

This is what the term “inverted yield curve” refers to — long-term interest rates being less than short-term interest rates.

To clarify here, the rates on longer-term Treasury bonds were less than the rates on shorter-term Treasury bonds.

But because these U.S. government-backed bonds are the foundation for many other interest rates, for simplicity I’ve chosen to use bank CDs to explain this.

Now let’s get to why you should care…

Here’s Why Investors Should Care About the Inverted Yield Curve

Dating back to 1969, the yield curve has been a perfect seven for seven at predicting recessions — meaning that it has inverted prior to every single one.

That’s a pretty impressive track record no matter how you slice it.

More recently, the relationship between the 2-year Treasury and the 10-year Treasury has predicted the last five recessions.

And with the curve once again inverting on Wednesday, some investors are worried that the sixth is on the way…

But don’t let this chart scare you just yet.

Here’s What to Do with Your Money

As long-term investors, we shouldn’t be quick to get sucked into the market’s latest hype. We need to think and act rationally.

So instead of selling out of all our positions, forgoing our reliable dividend payments, and waiting for a pullback, let’s look at how the last five inversions have played out.

After the 10-year Treasury yield falls below the 2-year Treasury yield (like it did on Wednesday), a recession occurs on average 22 months later.

And during the first 12 of those 22 months, the S&P 500 on average has gained 12%.

It’s not until month 18 when the stock market usually posts a negative return. And with the strong earnings that today’s corporations are posting, I cannot see why this time would be any different.

So for now, let’s not sell out of all our positions after the volatile last few weeks when the market has traded lower.

Instead, let’s continue to stay allocated to stocks and collect the reliable dividends that come with them.

In many cases, these payments are much larger than anything your bank could offer you at a time like this. And you still have the added bonus of price appreciation, which history says could be 12% in the coming year!

Now let’s get to the 5 Must Knows for the week…

5 Must Knows for Monday, August 19th

Earnings on Deck — On Tuesday, Home Depot, Kohl’s, Urban Outfitters, Cree, Medtronic, TJX, Toll Brothers and Madison Square Garden report earnings.

On Wednesday, Target, Lowe’s, Splunk, Nordstrom, Analog Devices, RBC, The Children’s Place and SQM report earnings.

On Thursday, Dick’s Sporting Goods, Salesforce, VMWare, BJ’s Wholesale Club, Ross Stores, Intuit, Gap, Hormel Foods, Toro and HP report earnings.

And wrapping up the week on Friday, Foot Locker and Red Robin report earnings.

Here’s What I’ll Be Watching — With so many high-profile companies reporting, there are bound to be insights into not only these individual companies, but the economy as a whole. Here’s what I’ll be watching.

Home Depot and Target are supposedly “Amazon-proof,” but are their businesses keeping pace? Or are they finally succumbing to the increased competition?

Other retailers that are not “Amazon-proof” also report this week, like Gap, Ross, TJX and Dicks Sporting Goods. So I’ll be watching to see if there are any notable turnaround stocks in the group.

All Eyes on the Fed (Again) — With interest rates being such a hot topic lately, any Fed events are being watched extra carefully now. This is especially true this week, because on Wednesday, the Federal Open Market Committee (FOMC) will be releasing its July meeting minutes, and on Friday, Powell will be speaking to kick off the Fed’s annual Jackson Hole Economic Policy Symposium.

This meeting follows the Fed’s first rate cut in more than a decade. And both of these events are expected to provide some additional light around its decision, as well as clues into their next move.

Huawei Catches a Break — Corporations both in the U.S. and abroad have been feeling the heat from the ongoing trade war, but Chinese telecom giant Huawei has really been devastated. Earlier this year, the Trump administration blacklisted the company and banned U.S. companies from selling their supplies to Huawei.

The Commerce Department granted Huawei a reprieve in May that is set to expire today. However, according to Reuters, the U.S. is expected to announce and a 90-day extension to that reprieve.

GE Update — After coming under fire last week from fraud investigator Harry Markopolos, General Electric (GE) is slowly responding to questions about its accounting practices.

“We operate with absolute integrity and stand behind our financial reporting,” wrote Steve Winoker, vice president of investor communications. In addition, CEO Larry Culp also bought $2 million worth of shares on the news, showing the company has full confidence that the company’s practices are fair and legal.

Here’s to keeping your edge,

Zach Scheidt

Davis Ruzicka
Managing Editor, The Daily Edge

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Davis Ruzicka

Davis Ruzicka is the Managing Editor of The Daily Edge. Davis is an experienced value investor with a degree in Finance from The University of Maryland. Today, Davis is pursuing his Chartered Financial Analyst (CFA) designation in his spare time while continuing to learn from seasoned investors Zach Scheidt and Alan Knuckman.

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