How Can a Yield Curve Affect Your Financial Future?
As you turn on your TV to watch some news, you’ve probably heard of investors and economists talking about the yield curve. The yield curve somehow makes most investors nervous, especially since it’s currently gearing towards a flattening yield curve. What does the yield curve exactly mean, and how does it affect our financial future? Let’s read and find out.
The Yield Curve
To put it simply, the yield curve represents the relationship between the interest rates of bonds with different maturities with the same credit quality. Most of the time, you’ll hear the yield curve when economists and financial experts talk about the U.S. Treasury Bonds using the 3-month, 2,5,10 and 30-year securities. So why should investors need to monitor and care about the yield curve? According to the economists, the yield curve serves as an indicator of the economy’s health. While this may sound too technical to the public, the yield curve creates a domino effect once it affects the interest rate movements.
The yield curve can take three shapes mainly:
Normal Yield Curve
This is where most longer-term bonds have higher interest rates. This yield curve is generally preferred since it’s a sign of a progressive and healthy economy. The economists even claim the economy continues to expand when we have a normal yield curve.
Flat Yield Curve
This means that long-term bonds have the same yield as short-term bonds. This is often a sign of a transitioning economy from expansion to a recession (vice versa).
Inverted Yield Curve
This means that short-maturity bonds have higher interest than longer-maturity bonds. This is a clear indication of an upcoming recession. As of Monday this week, the yields for the five U.S. Treasury bonds are 2%, 2.65%, 2.81%, 2.94% and 3.08% from shortest-longest maturity respectively. Although the yields still project a normal yield curve, the economists noticed it flattened significantly for the past few months.
Despite the yield curve’s current movements, some economists claim that the US Economy is not going back to recession as of this time. According to the new Fed chief Jerome Powell, the American economy isn’t showing any signals of recession despite the flattening yield curve. He claims that inflation was allowed to get out of control last 2008, causing the Fed to tighten and put the U.S. economy into a recession. Powell said that the current Administration is closely monitoring the inflation and have provided contingency measures to beat it.
Meanwhile, the hedge fund Infrastructure Capital Advisors CEO Jay Hatfield commented on Powell’s statements and said it’s worrisome to hear it from the Fed chief himself, especially since the yield curve is close to an inversion. If anything, the flattening yield curve is the most reliable economic indicator as what Hatfield learned from studying the history of Economics. So he urges Powell to take this indication more seriously and to prepare some countermeasures to prevent America from going into another recession.
Meanwhile, David Kotok of Cumberland Advisors says they are closely monitoring the yield curve like a hawk. But he echoed Powell’s statements and said he’s not worried about any downturn for the meantime. He argued that the tax cuts on corporations help boost the economy and the government spending is still powerful to offset any Fed interest rates tapping that may impede the nation’s economic growth.
What Can You Do as An Investor?
Most professional investors don’t even dare to analyze the yield curve critically. They just stick to their portfolios’ interest rates and monitor it before it hits their benchmark. Aside from that, they mainly let the asset allocation and security selection handle their money to drive relative returns despite the risks.
If you’re worried about the flattening and possible inversion of the yield curve, most economists recommend you stick with your bond allocation, especially for those longer-term bonds for your investment goals. This can help offset the equity market declines either in stocks or treasury bonds. Most long-term bonds securities can give a guaranteed return in the long-term despite having a next recession or stock market crash.
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