By now you know that on August 14, the United States bond market saw the yield on 2-year Treasury notes climb above the yield on 10-year Treasury notes. The “2-10 spread” is a significant marker for analysts. An inversion in this spread has occurred in advance of the last nine recessions, with the most recent inversion taking place in 2007. The yield curve has been flattening for quite some time, but hearing that the yield curve had inverted spooked investors. All the major stock exchanges suffered major losses and finished down for the week.
Why did the yield curve invert?
One of the first things that the naysayers said about the inverted yield curve is “this time it’s different”. According to these analysts, one of the reasons behind the inverted yield curve is a lack of global growth. Some European central banks have instituted negative interest rates which are making U.S. Treasuries a safe investment. As more money flows into long-term bonds, the yield goes down pushing down the long end of the curve.
This is not to say there is no concern in the United States. An inverted yield curve creates uncertainty with corporations who may begin to put off projects or other capital investments as they wait for clear signals about the global economy.
How to invest when the yield curve inverts
At times like this, the question on investors’ lips is “what do I do now?” The simple answer is to be patient, but stay informed. The reality behind an inverted yield curve is that, even if it does lead to a recession, it is not likely to happen right away. In fact, on average it can take over a year for the economy to move from an inverted yield curve to the point where the economy teeters into recession. An accepted indicator of a recession is two consecutive quarters of declining GDP growth that is usually accompanied by a rise in unemployment. The current economic numbers do not support an imminent recession.
But the simple answer of “standing pat” is not the answer for every investor. An inverted yield curve is signaling that a dollar in the future will be less than a dollar today. That would be a negative story for equities since investors buy stocks with the idea that the price will go up over time. And the presence of an inverted curve shows that there is volatility in the market. Like any investment strategy, an investor needs to consider their return objectives, time horizon, and risk tolerance when choosing the right approach.
With that said, here are three strategies you can use if you’re concerned about the inverted yield curve and want to take steps to ensure your portfolio is protected during these volatile times.
Aggressive investors can buy on the dips
History has shown that regardless of whether a recession occurs or not, the initial period after a yield curve inversion tends to be a very good one for stocks. In the past 30 days, the major stock exchanges (DJIA, NASDAQ, S&P 500) are down approximately 5%. Many investors were already starting to look for stocks that were “on-sale” before the yield curve inverted. Knowing the historical trend is good for equities in the months immediately following a yield curve inversion can make this a good time to profit from buying stocks on sale.
Rebalance to a more defensive portfolio
Investors with time on their side may want to stay invested in stocks. However, one strategy they can take is to practice diversification by rebalancing their portfolio with defensive stocks. A defensive stock is a company that does business in a sector that stays steady in any economy. These stocks will not have flashy capital growth, but they will also be less likely to suffer the significant losses that can happen with growth stocks. Many defensive stocks also pay dividends and some of them have long-standing histories of increasing their dividends year after year. The best dividend stocks provide the benefit of predictable income along with the opportunity for capital growth. While the technology sector has remained strong, there is some evidence that investors are beginning to flock to shares of consumer staples and utilities (two classic defensive stocks). Mutual fund investors can achieve a similar result by looking at a mutual fund or exchange-traded fund (ETF) that specializes in a particular defensive sector, such as the Utilities Sector SPDR ETF (XLU).
Take advantage of bond barbells and ladders
The price of a bond and its yield have an inverse correlation. As yields fall, investors are willing to pay a premium for bonds that have a yield higher than the current market rate. However, bond yields and interest rates move in opposite directions. With the likelihood that the Federal Reserve will move to lower the Federal Funds rate, it is safe to assume that the market will begin to price in this rate cut to long-term bond rates. But with so much unknown, a prudent strategy may be to create a bond barbell or bond ladder.
A bond barbell is a bond strategy in which investors buy bonds with different types of maturities: some short-term and some long-term. It is called a barbell because, buying short-term bonds and long-term bonds and nothing in-between, gives the maturity allocation a barbell shape with two weighted ends. This strategy allows investors to take advantage of higher rates that exist in short-term bonds today and lock-in a long-term yield. A safe strategy is to look for maturities in the 3-year range on the low end and the 7-year range on the high end.
A bond ladder allows investors to reinvest bond proceeds that are maturing at different intervals into new bonds so they will always have bonds maturing on a regular basis. For example, an investor with $60,000 to put into bonds may choose to put $20,000 into a two-year bond, $20,000 into a five-year bond, and $20,000 into a ten-year bond. The basic idea is to always have bonds that are maturing on a regular basis. If interest rates are lower in two years, the short-term bonds may lose some of their value, but it will make buying long-term debt more attractive.