Earlier this week, the yield curve inverted, sending shockwaves of volatility through the stock market.
Well, what exactly is the yield curve and why does everyone make a big fuss when it inverts?
A yield curve shows the relationship between Treasury bonds of different maturities and their corresponding expected return if you were to hold that bond for the entire length of the term.
Under normal economic conditions, you would expect that the shorter-term Treasury bonds return less than longer term Treasury bonds.
This makes sense, because when you buy a 10 Year Treasury Bond for example, which means you are lending the US Treasury money that won’t be paid back to you for another 10 years, you expect to be compensated more than someone else lending to the US Treasury over only a 3 month time period.
Do you notice how the yields increase with the longer each maturity is? Good. When you plot these maturities and connect the dots with a line, the yield curve will form and will be upward sloping during normal economic conditions.
So, when you hear that the yield curve has inverted, this means that the opposite situation has occurred, or in other words, some or all shorter-term Treasury bonds have a higher yield than some or all longer term Treasury bonds.
Earlier this week, the 3 month, 1 year, and 2 year Treasury bonds were paying more than a 10 Year Treasury bond. What this means is that bond investors are expecting economic growth to be lower in the near future.
In our opinion, this will force the US Federal reserve to cut interest rates further. Additionally, we believe that the Fed seems very willing to do so.
If these interest rate cuts come to fruition, it may create a very positive environment for risk assets like stocks and high yield bonds to appreciate in value further.
With Round portfolios already having higher than normal concentrations to safe-havens as of late, we are well poised to take advantage of any opportunities that may arise from the Fed’s potential actions.
FYI, if you haven’t seen the performance update we sent out earlier this week, you can view it here.
Hope you have a great weekend,
Saul & The Round Team