The Game of Investing, Vol. 8
- Real Vision
- April 28, 2023
This Week…
We’re tackling the yield curve — what it is, what its inversion means for markets, and how it can help us understand the economy.
Our expert today is Mike Coolbaugh, Real Vision contributor and chief strategist at Element Macro Research.
- “Equity markets are higher to start 2023, but this year hasn’t been any easier than 2022,” says Mike. “Understanding the relationship between yields, stocks, and the economy is key to blocking out the noise.”
In this issue, we’ll cover 3 things:
- What is the yield curve and how does it function?
- What an inverted yield curve means for investors.
- Using the curve as an indicator.
Let’s dig in.
Welcome to The Game
The Game of Investing Newsletter…
…a bi-weekly newsletter where you learn from investing pros about how this game actually works.
Because learning about finance shouldn’t be boring.
LEVEL 1 — Understanding the Yield Curve
A yield curve is a line that plots the interest rates (aka yields) of bonds with different maturities. The curve reflects the spread between short-dated bonds and long-dated bonds.
The 2 yield curves most popularly used by economists are the 2Y-10Y curve and the 3mo-10Y curve.
- The 2Y-10Y curve plots the spread between U.S. 10-Year Treasury yields and U.S. 2-Year Treasury yields.
- The 3mo-10Y curve plots the spread between the 10-Year Treasury yield and the U.S. 3-Month Treasury bill rate.
In a strong economy, the curve points upwards as longer-dated bonds yield higher interest rates than shorter-dated maturities.
- “The long end of the curve is driven by expectations of future economic growth,” says Mike. “This is a sign of economic health, and it signals strength for assets.”
Level 2 — Yield Curve Inversion
When a yield curve inverts, it means that long-term interest rates are worth less than short-term rates.
- This happens during times of economic uncertainty, and it’s generally accepted as a recession signal (but more on that later…).
These days, the yield curve is sharply inverted.
- The 3m-10Y spread widened to an all-time low of -1.72% in mid-April.
- The 2Y-10Y spread is around -0.50. That’s just the seventh sustained inversion of the last 50 years.
The Federal Reserve uses rates as a tool to stimulate growth (by lowering rates) or stifle it (by raising rates).
- “So when the Federal Reserve raises its Fed funds rate to slow the economy and combat inflation, short-term yields tend to move higher,” says Mike.
Level 3 — Inversion as a Recession Indicator
A sharply inverted yield curve is a sign that the market anticipates an economic slowdown.
- The 2Y-10Y yield curve has inverted 6-24 months before each recession since 1955. However, since 1990, the first inversion has never led directly to a recession.
- The 3mo-10Y spread has a slightly better track record as a recession indicator and it’s the one relied on by most academics.
🔑 The takeaway: Not every inversion guarantees a recession, but a sustained inversion is usually a reliable indicator. As investors, understanding the forces that drive the business cycle is pivotal to finding success in the markets.
Next Time
Thanks for reading. In our next issue, we’ll dig deeper into the basic market drivers that every investor needs to understand, no matter your time horizon.
See you then.
Have feedback on The Game of Investing? We’d love to hear it.
Just email us at essential@realvision.com to share your thoughts.
The Game of Investing Newsletter…
…a bi-weekly newsletter where you learn from investing pros about how this game actually works.
Because learning about finance shouldn’t be boring.