Opinion: Inverted yield curve may not mean a recession is near

You may have heard about the so-called inverted yield curve and how financial markets were particularly volatile in their reaction to it. What is an inverted yield curve and what does it mean?

Simply put, a yield curve inversion occurs when short-term bonds pay more than long-term ones. Yields are normally higher on fixed-income securities with longer maturity dates.

If you can picture a standard X-Y axis graph we all learned about in school, the normal yield curve plots out visually as an upward sloping curve from left to right. It’s an indicator of a healthy, growing economy. But when that curve flips, as short-term interest rates become unnaturally higher than their long-term counterparts, it’s a warning sign that something is off. It’s a caution light that something may be changing on the road ahead.

Before this month, the yield curve hadn't inverted since 2007, just before the Great Recession. And the time before that was 2000, just before the internet stock implosion. Yield curve inversions tend to get everyone's attention in financial markets. And they’ve been a reliable and accurate indicator in the past of an impending recession – seven for seven in the last few decades.

Today, there are some reasons to think the yield curve is not telling us everything it used to, and we need to be mindful of that. What may be different this time are the reasons for a new normal that will find us having a flatter yield curve than we are used to seeing.

The biggest factor driving this change is that the yield curve has been distorted by more than $15 trillion-$17 trillion worth of foreign bonds that pay negative interest rates. Think about that for a second: Global investors are paying their governments to hold their cash. Since the 2008 financial crisis, economic growth, inflation and central bank policy around the globe have not yet been able to return interest rates to historically normal levels. Rates were lowered to zero, and even below in some cases, to fight the Great Recession. And global interest rates and bond yields have remained low all through the recovery and expansion that followed.

Now, these negative global interest rates and economic uncertainties are driving investors worldwide to buy U.S. Treasury bonds, and all that purchasing pushes yields down.

In addition to the negative global interest rates just mentioned, there are at least two more related reasons.

The first of these has to do with the ongoing quantitative easing that central banks in the United States, Europe and Japan are implementing. Simply put, these banks have been buying up longer-dated government bonds, and this of course takes supply out of the market, driving rates down.

Secondly, global demographics are suppressing yields, too. As societies age and birth rates slow, interest rates have historically come down as investors rotate from consumption to saving. We’ve seen this over the past two decades in Japan, the past decade in Europe and now in our U.S. population where growth has slowed. So low global rates, quantitative easing and demographics are pushing rates down, likely creating a flatter curve than which we are historically accustomed.

While we don’t feel a recession is immediately on the horizon, we are in our longest expansion in U.S. history without one. I can say that eventually there will be a recession. The timing and causes are the big question.

Recessions are painful in general — they average a drop of 32-37% in the S&P 500. You might recall the last two recessions were even worse with 55% and 50% drops, respectively, in the S&P 500. That can turn your 401(k) into a 201(k) in a hurry.

Businesses want certainty so they can feel confident about future investments. Even though we are still optimistic, an inverted yield curve has historically signaled a recession is possible within a year of inversion. A recession is two consecutive quarters of negative growth. The last two were severe. That said, we could have a mild recession and start a new expansion. They don’t all have to be as severe as the last two.

Peaks and valleys of the business cycle are a natural part of investing. The nature of the market is to move up and down during the short term, so attempting to time the market is nearly impossible.

Investors should work with their advisers, set a strategy to meet personal goals and stick to it. Focus on what you can control. Limit the noise by tuning out the hourly social media investment chatter. You can make better decisions by communicating with your adviser, reaching appropriate diversification in your portfolio and avoid missing upswings in a volatile market.

Remember that we’ve added about 18,000 points to the Dow Jones Industrial Average since 2009 and about 2,000 points to the tech-heavy S&P 500. We’ve had a great run, and yes, there will be a recession some day. We just don’t think it’s going to happen in the near term.

Don Davis is a vice president and portfolio manager with Commerce Trust Co. in Springfield. He can be reached at don.davis@commercebank.com.