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Should You Worry About an Inverted Yield Curve?

JDH Blog
Larry Swedroe, Chief Research Officer with Buckingham, 8/20/2019

Ever since December 3, 2018, when the yield curve inverted (with the yield of 2.83 percent on the five-year Treasury note one basis point lower than the yield of 2.84 percent on the three-year Treasury note), I have been receiving calls and emails from investors worried about the impact of an inverted yield curve. The reason they are anxious is the much-publicized relationship between inversions and recessions — inverted yield curves have predicted all nine U.S. recessions since 1955.

You can observe the relationship in the following chart from WealthManagement.com, which shows the yield spread between two-year Treasury notes and 10-year Treasury notes (the traditional measure for inversions) during the most recent recessions (shaded in gray).

Recent history shows that a recession follows yield curve inversion in an average of 16 months, and the setback lasts, peak to trough, for an average of 12 months.

While we have not had a recent closing with the 10-year yield below the two-year yield, during trading on August 14, 2019, the yield on the 10-year Treasury note fell to one basis point below the yield on the two-year Treasury note, reigniting fear about a recession. As I write this on August 16, 2019, the spread was a positive six basis points.

Before tackling whether or not this should worry you, it’s worth noting that on December 3, 2018, the S&P 500 Index closed at 2,790. On August 16, 2019, it closed at 2,891, a gain, not including dividends, of about 3.6%. Including dividends, the return would have been about 5% — well above the return available on cash during the period. It’s also worth noting that, given concerns about a slowdown in global economic growth, at its July meeting the Federal Reserve reduced the federal funds rate by 25 basis points, and the market expects two more cuts of the same amount by the end of the year.

So, with that said, should investors be concerned, or acting, based on the recent inversion?

To begin, it is important to understand that what matters is not just the relative level of interest rates but also whether the Fed’s policy is accommodative or contractionary. The reason we have experienced recessions after inversions is that Fed policy was contractionary as it tried to fight inflationary pressures. By raising short-term real interest rates to levels sufficient to slow demand and fight inflation, the Fed can cause an economic slowdown and even an outright recession. With this understanding, we should ask whether Fed policy is currently in a contractionary or accommodative regime.

When it comes to monetary policy, it is the level of real interest rates, or the inflation-adjusted federal funds rate, that matters. On average, the real federal funds rate is positive. Over the last seven decades, it averaged about 1.3%. We fell well below that level in January 2008, when the Fed slashed rates to try to prevent a depression. The Fed has kept policy accommodative since then. The latest forecast from the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters is for inflation to be just 1.9 percent in 2019. With the current three-month Treasury bill rate at 1.86%, we have a real three-month Treasury bill rate of essentially zero, well below the historical average of 1.3%. Clearly, monetary policy is still accommodative and supportive of economic growth. As long as the real federal funds rate remains at relatively low levels, investors should temper any concern they have about an inversion in the yield curve.

In addition to relatively loose monetary policy, we also have massively stimulative fiscal policy, with the budget deficit at about $1 trillion. That doesn’t mean a recession is impossible, as one can be caused by exogenous events, but it isn’t going to be caused by monetary or fiscal policy that is too tight.

Observe also that while the yield curve inverted in December, the July unemployment rate fell to 3.7%, down from January’s level of 4%. Moreover, the latest consensus forecast of professional economists is for GDP growth in 2019 of 2.3%, and growth in the third and fourth quarters of 1.8% and 2.0%, respectively. In addition, the forecast for 2020 is for growth of 1.9%.

Another reason you should not focus on the slight inversion we have experienced relates to the fact that the flattening of the yield curve has mostly occurred at the longer end. While U.S. interest rates are well below historical levels, they are still well above those of most other developed countries. For example, on August 16, 2019, the yield on 10-year U.K. Gilts was just 0.46%. The yield on 10-year German Bunds was slightly negative at -0.69%. The yield on Japanese 10-year government bonds was also negative at -0.24%. Rates have fallen so sharply that we now have more than $15 trillion in government debt with negative interest rates.

Those low yields have led the U.S. Treasury bond market to attract capital, suppressing our longer-term yields and flattening the curve. Normally, a flattening yield curve might signal that the market is expecting weaker economic growth. However, today, that flattening could just as likely be a result of “safe-haven demand” — capital flowing to the United States because our economy is less likely to be negatively impacted by a trade war, as the percentage of our GDP that is exports (about 12%) is only about one-fourth of the percentage of the Eurozone’s GDP that is exports (about 46%) — and the global search for higher yields.

There’s one other important point to remember: If the yield curve inverted further due to a weakening of the economy, it is likely that Fed policy would become even more accommodative, reducing the risks of a recession and a bear market.

As the perspective I offer is always based on the evidence, let’s now turn to the evidence on stock returns following inversions.

Stock Returns Following Yield Curve Inversions

In an August 2018 article, “What Does a Yield Curve Inversion Mean for Investors?”, Dimensional examined the returns to stocks following inversions for five major developed nations, including the United States, since 1985. The article states: “Equity returns (as measured by MSCI local currency indices) were a mixed bag in the three years following an inversion, with US index returns higher 66% of the time at the 12-month mark and only 33% of the time 36 months later. When all countries are included, returns of the indices were higher 86% of the time 12 months later and 71% of the time 36 months later.” Dimensional concluded: “It is difficult to predict the timing and direction of equity market moves following a yield curve inversion.”

My colleague, Jared Kizer, also looked at returns following yield curve inversions. Jared examined inversions, defined as the spread between two-year and five-year Treasuries, and found that the three years following one produced a total market beta premium of just under 3%, and the five years following one produced a total market beta premium of almost 11%. Jared also noted a very wide range of outcomes for the market beta premium over both horizons, but particularly for the five-year period. Among five-year periods, four results had negative total returns (although two of these overlap), with two of them being negative total returns in excess of 30% (the largest negative total premium was -42%). However, in some five-year periods, the total market beta premium was substantially positive, with a few results in excess of 50% (the largest was 69%). In other words, U.S. stock market returns have tended to be lower than their historical average, but still positive, following periods of yield curve inversion.

The bottom line is that while an inverted yield curve may be a reliable indicator that a recession is likely to begin, on average, within 16 months, it is not an indicator reliable enough to allow you to profitably time stock markets. That should not come as a surprise, as there is no evidence that active managers have been able to exploit any signal provided by well-publicized information on the predictive nature of yield curve inversions. If there were any such evidence, we would see it in the annual S&P Dow Jones Indices versus Active (SPIVA) scorecards. But none exists, in either the stock or the bond market.

Remember, if information is well known, any predictive value it contains already is built into current prices. Thus, it’s unlikely you can use it to generate outperformance. Investors fail to differentiate between information and value-relevant information, unfortunately trading on what is nothing more than valueless information. Certainly, if you hear it on TV or read it in the newspaper, it is way too late to act on it.

Summary

There will always be something for investors to worry about, which is why Warren Buffett warned that once you have ordinary intelligence, success in investing is determined far more by temperament — the ability to ignore the noise of the markets and adhere to your well-thought-out plan that incorporates the risks of negative events. Hopefully, your plan reflects the certainty that negative events, including non-forecastable Black Swan events, will occur with a high degree of regularity and ensures that you are not taking more risk than you have the ability, willingness and need to take. Getting that right raises the odds that your head, not your stomach, will be making investment decisions. I’ve yet to meet a stomach that makes good decisions.

Lastly, ask yourself this question: Is Warren Buffett spending even one minute worrying about a yield curve inversion? The answer almost certainly is no, because he has said he hasn’t even looked at, or listened to, an economic or market forecast in more than 25 years. One of the great anomalies in finance, which I point out in my book “Think, Act, and Invest Like Warren Buffett,” is that while investors idolize Buffett, they not only fail to follow his advice but often do the exact opposite, to their great detriment.

The strategy most likely to allow you to achieve your financial goals is to develop and adhere to a long-term plan in line with your ability, willingness and need to take risk. By doing so, you will be better able to focus on investing in a systematic way that will help you meet your long-run objectives.

 

A version of this article previously appeared on ETF.com.

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2019, The BAM ALLIANCE®

September 13, 2019/by Matt Delaney
https://jdhwealth.com/redesign/wp-content/uploads/2018/06/JDH-Logo-Square-Color-Transparent-RGB-1.png 0 0 Matt Delaney https://jdhwealth.com/redesign/wp-content/uploads/2018/06/JDH-Logo-Square-Color-Transparent-RGB-1.png Matt Delaney2019-09-13 20:24:242019-09-17 19:42:57Should You Worry About an Inverted Yield Curve?

Financial Illiteracy’s High Cost

JDH Blog, Larry Swedroe, The BAM Alliance

by Larry Swedroe, Director of Research, 6/14/2018

It’s a great tragedy that despite its obvious importance to everyone, our educational system almost totally ignores the field of finance and investments. This is true unless you go to an undergraduate business school or pursue an MBA in finance.

Eighteenth-century English poet Thomas Gray wrote, “Where ignorance is bliss, Tis folly to be wise.” When it comes to investing, ignorance certainly is not bliss—it pays to be wise. Just ask investors who lost tens of billions of dollars in the Bernard Madoff scandal. Without a basic understanding of how capital markets work, there is no way individuals can make prudent investment decisions.

The sad fact is that surveys have shown fewer than half of U.S. workers have even attempted to estimate how much money they might need in retirement, and many older adults face significant retirement shortfalls. While educational achievement is strongly positively associated with wealth accumulation, research also has found financial literacy has an even stronger and larger effect on wealth.

Households that build up more net wealth may be better able to smooth consumption in retirement, and financial literacy enhances the likelihood people will contribute to their retirement savings. Compounding the problem of lower savings is evidence that less financially literate households experience lower risk-adjusted returns.

Financial Literacy Research

Milo Bianchi contributes to the literature on financial literacy with the study “Financial Literacy and Portfolio Dynamics,” which appeared in the April 2018 issue of The Journal of Finance.

Using data obtained from a large French financial institution, Bianchi observed portfolio choices in a widespread investment product called assurance vie, in which households allocate wealth between relatively safe and relatively risky funds—predefined bundles of bonds or stocks—and are able to rebalance their portfolios over time. Assurance vie contracts are prevalent in France, being the most common way households invest in the stock market.

Bianchi then combined this data with responses to a survey he conducted with the financial institution’s clients. The survey, which ranked investor sophistication levels on a scale between one and seven, allowed him to obtain a broader picture of clients’ financial activities outside the company and of their behavioral characteristics. While investments in assurance vie may not cover a household’s entire portfolio, they often represent a substantial portion of investors’ financial wealth.

The author’s final database incorporated portfolio information at a monthly frequency for 511 of the financial institution’s clients over the period September 2002 to April 2011. On average, the assets it covered were approximately 50% of a household’s financial wealth.

Following is a summary of his findings:

  • Financial literacy correlated with demographic variables; in particular, education and wealth.
  • Financial literacy was negatively correlated with being female—a gender gap that had been observed in prior studies.
  • An additional unit of financial literacy was associated with a 3.5% increase in the probability of holding stocks.
  • More literate households experienced higher portfolio returns.
  • Controlling for various measures of portfolio risk, the most literate households experienced yearly returns approximately 0.5% higher than the least literate households, relative to an average return of 4.2%. These magnitudes were in line with those found in a recent study of Dutch households.
  • There was no evidence that, overall, households with higher financial literacy choose riskier portfolios. Instead, their risk exposure varies systematically with market conditions, allocating more to risky assets when they have higher expected returns. A 1% increase in the expected excess return of risky funds was associated with a 2% increase in the risky share for each unit of financial literacy.
  • Decomposing the observed changes in the risky share over time into active changes due to portfolio rebalancing and passive changes induced by differential returns to risky versus riskless funds, Bianchi found that passive changes were relatively more important for less sophisticated households. For the least sophisticated households, passive changes accounted for 64% of the total change in the risky share over 12 months. For the most sophisticated households, by contrast, passive changes accounted for 30%. This demonstrates that households with lower financial literacy display greater portfolio inertia. More educated, older and female investors display lower levels of inertia.
  • More literate households were more likely to act as contrarians. Rebalancing, they tended to move their wealth toward funds that had experienced relatively lower returns in the past.
  • The returns more sophisticated households actually experienced tended to exceed the returns they would have earned without rebalancing their portfolios. More sophisticated households were more likely to buy funds that provided higher returns than the funds they sold.

Conclusion

Findings such as these demonstrate that financial illiteracy is costly. The fact that our educational system has failed to provide much of the public with what I would consider even a basic level of financial literacy certainly is a tragedy. (The research shows this is not a U.S.-only problem.) But perhaps the bigger tragedy is that so many apparently would rather watch some reality TV show than “invest” the time and effort to become financially literate.

I have now authored or co-authored 16 books on investing, presenting the evidence from academic research. This has been my way of trying to reduce financial illiteracy and help prevent investors from being sheared by the wolves of Wall Street. Others, such as John Bogle and William Bernstein, have written outstanding books on the principles of prudent investing.

The only problem is that the sales of Harlequin romance novels (not that there is anything wrong with them) are far greater than the sales of books on modern portfolio theory and efficient markets, providing one explanation for why investors continue to use nonfiduciaries as their advisors and adopt active management strategies—strategies with a high likelihood of failure.

The bottom line is that the greatest investment you can make, and the one with the highest expected return, is an investment in your own financial literacy. Remember, if you think the price of financial education is too high, just try the price of ignorance.

This commentary originally appeared June 4 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2018, The BAM ALLIANCE®

June 20, 2018/by Matt Delaney
0 0 Matt Delaney https://jdhwealth.com/redesign/wp-content/uploads/2018/06/JDH-Logo-Square-Color-Transparent-RGB-1.png Matt Delaney2018-06-20 19:22:562018-08-14 03:35:37Financial Illiteracy’s High Cost

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