The Federal Reserve (Fed) is the U.S.'s central bank, responsible for creating and enforcing monetary policies, overseeing financial institutions, and maintaining the financial system's stability. Part of making sure the financial system is stable is keeping inflation at decent levels, which has been an issue for the past couple of years.
To fight high inflation, the Fed has been consistently raising interest rates. As of July 2023, interest rates have increased 11 times since March 2022, going from 0.25% to 5.50%. For investors in fixed-income investments, rising interest rates have translated to higher rates on U.S. Treasuries and deposit accounts like checking and savings accounts. However, these increases may spell trouble ahead.
Image source: Getty Images.
The inverted yield curve is getting steeper
The U.S. yield curve is a graph that shows the interest rates of U.S. Treasuries over a different range of maturities. In "normal" times, the yield curve slopes upward to the right because investors earn higher yields the longer it takes a bond to mature.
In practice, a typical yield curve makes sense. What incentive would someone have to buy a longer-term bond when they can earn more while having their money locked up for a shorter period? Chances are they wouldn't, which is part of the problem with the current U.S. yield curve.
Image source: www.ustreasuryyieldcurve.com. Data as of Aug. 14, 2023.
With the Fed raising interest rates, short-term rates between four to 52 weeks are noticeably higher than longer-term bonds over five years. It's a hard sell to convince someone that a 10-year bond at 4.2% interest is a better investment than a four-week bond of just over 5.5%.
How should investors take the inverted yield curve?
The inverted U.S. yield curve could be a warning sign for several reasons. If banks can earn more money by holding on to short-term Treasury bonds than by lending for a longer timeframe, they may decide to slow down long-term lending (like mortgages) to maximize short-term profits. It makes more sense to use funds to earn over 5% interest within a year than to lend money out and earn just above that for a 30-year mortgage.
The main problem with the inverted yield curve is the historical implications. The current inversion of the U.S. yield curve hasn't been this steep in close to four decades and is often a sign of an approaching recession.
According to the New York Federal Reserve, the term spread -- the difference between the three-month and 10-year Treasury rates -- indicates a 66% chance of a U.S. recession by July 2024.
Image source: New York Federal Reserve.
Despite the high probabilities based on this indicator, it's important for investors not to take it as the end-all be-all. If anything, it should be a "Let me prepare for the worst and hope for the best" scenario. You can't control recessions or economic downturns, but you can control how you approach them.
Certain sectors (such as utilities, consumer staples, and healthcare) tend to thrive during recessions because they provide products and services that people need regardless of economic conditions. A lot of expenses will be cut from someone's budget before power, cellphones, or medicine.
The opposite is typically true for certain sectors (like consumer discretionary, financials, and real estate) that tend to have down periods during recessions. Even with that being the case, you don't want to let the economy completely dictate your investing plan because it could be toeing the line of attempting to time the market and throw off your portfolio allocation.
There's nothing wrong with adjusting to the economy. For example, people closer to retirement may decide now's the time to allocate more of their portfolio to more stable, blue-chip stocks to protect against wild swings right before they need access to their money. Or younger investors may decide to increase how many financial stocks they buy because they're trading at a "discount" and have more time to wait for them to recover.
The goal should be staying the course while being open to taking advantage of opportunities as they become available.
The economy is cyclical in nature, and recessions are a natural part of that. That doesn't make them any easier to handle, but it should emphasize the importance of keeping a long-term focus. Adjust, but don't deviate completely.
