Unless you follow investing closely you may never have heard of the “yield curve” and may not realize how much impact it has on your life. The yield curve predicts to some extent your income over the next few years, whether or not you’ll be able to borrow money and how your portfolio is likely to perform. In this post will explain what the yield curve is and what it means for you.
What is the Yield Curve?
The yield curve is the difference between long-term interest rates and the short-term interest rate. On surface that sounds like a pretty confusing concept, but let’s dig into it.
In our economy there is a short-term interest rate that is set by the Federal Reserve. That interest rate dictates how much banks can borrow for in the short-term. The long-term interest rate is what investors think is a satisfactory rate to loan money for across 10 or 30 years. Investors forecast the long term rate based upon what they think economic growth and inflation is going to be. The difference between the long term and short term interest rate is called the yield curve slope. If long term interest rates are lower than short term interest rates, it is called an “inverted yield curve”. Right now, long term interest rates are barely higher than short term interest rates and market commentators fear that it is close to becoming inverted. See graph below.
How An Inverted Yield Curve Could Affect You
An inverted yield curve, where long term rates are higher than short term rates predicts a number of big things that affects your life.
#1: Makes It Hard To Get A Mortgage
All banks are in the business of borrowing money for short periods of time (e.g through offering you a 1 year certificate of deposit that pays interest) while loaning people money for long periods of time (e.g by providing 30 year mortgages). The profit of the bank is the extent to which it can keep borrowing at these shorter-term interest rates and use that money to then loan you and I money at longer-term interest rates.
Put another way, a bank’s profitability is determined to what extent long-term interest rates are higher than short-term interest rates. If long term interest rates are a lot higher than short-term interest rates banks should be very profitable as they are able to borrow money at favorable short term rates while lending money out at much higher long term rates. If the yield curve is inverted and long term rates are lower than short term rates, it isn’t profitable for the bank to loan money. This has a big impact on whether they want to offer you a loan, such as a mortgage.
What You Can Do
If you need to buy a home or take out a mortgage, it may make sense to do it before the yield curve is inverted and banks are unwilling to lend. We are getting close to that territory.
#2: Impacts Your Income/Job Prospects
Because the shape of the yield curve has an impact on whether banks lend money, it also predicts whether customers can receive credit to spend and businesses can receive financing to grow. If they can’t, people may consume less and companies may choose to hire fewer workers. When we look at the history of the yield curve from 1975 onwards and isolate every situation where the yield curve is inverted, we find that the subsequent month had a higher unemployment than the month before it.
This means that it’s more likely that you are you may be laid off or that your income may shrink as businesses contract and lay off workers.
What You Can Do
If you don’t have enough money saved to be able to cover your expenses for the next few years now is a good time to think about saving more or reducing your expenses.
#3: May Hurt Your Portfolio’s Returns
If you’ve been invested in the market over the past 10 years you’ve experienced a remarkable bull market and have realized a return of 270%. We looked through the history of the yield curve from 1975 and isolated every month where the yield curve was inverted. We found that on average the S&P 500 returned 0.5% after a month where the yield curve was inverted and 0.8% after a month the yield curve was not inverted.
When we dig in deeper, we notice that even those the stock market is up 0.5% on average after a yield curve inversion, the return carries significant risk, with 10% of months experiencing price drops of greater than 5%.
What You Can Do
It makes sense to always be invested in the market and not try to buy or sell based on predictions of when the market is going to go up or down. There is a sea of research that shows that trying to time the market is a fool’s errand. However, that is likely little comfort to an investor or saver who doesn’t want to lose any of their hard-earned money, but still wants to capture some of the upside the market can offer. It actually possible to construct a portfolio where you receive some market upside while being protected from losing any money. You can implement this strategy on your own in a brokerage account by reading our previous post here.
#4: Makes Long Term Certificates of Deposit Unattractive
Typically when you buy a certificate of deposit or a fixed annuity (the insurance industries version of a CD), the longer you lock up your money for, the higher the interest rate you receive. If the yield curve is inverted this might not be the case. You could very well receive the same yearly interest rate for committing your money for 10 years compared to committing your money for 2 years. Therefore, yield curve inversion can make locking your money up for longer periods a bad deal.
What You Can Do
If long term interest rates are the same or lower than short term interest rates on CDs or annuities, it makes sense to invest in the shorter term annuity and wait, since you are not being compensated for locking your money up.