When equity markets are behaving normally, bond yields correlate with their maturity dates. In other words, a bond that matures in a decade will have a higher yield than one that matures in three months. However, in some cases, you’ll see an inverted yield curve in which shorter-term debts have a higher rate of return than longer-term debts. Let’s take a look at why that happens, what it supposedly means for the economy and why such an inversion may not be much of a signal for investors.
Why Are Yields and Maturity Dates Often Correlated?
There are a couple of key reasons why a 10-year bond would typically have a higher yield than one that matures in 90 days. First, there is greater risk in committing your money for a decade as opposed to a matter of months. This is largely because you can’t predict what will happen more than a few months out. Therefore, you could potentially invest during a period of economic stability and then watch as your investment craters because of a major recession several years later.
Another key reason why rates are higher on longer-term bonds is that the opportunity cost is greater. While your money is tied up in a bond, it means that you can’t invest in a hot stock, a startup business or some other venture that might offer a higher return. Therefore, yields have to be priced in a way that attracts long-term investors.
What a Yield Curve Inversion Says About the Economy
In theory, an inversion of the yield curve means that investors expect interest rates to fall over the next several years. This is generally what happens when an economic recession occurs. During a recession, stock prices either fall or are flat compared to years of economic prosperity. Therefore, investors may choose to rotate their money out of stocks into bonds and other investments that are considered to be safer.
This is why the media tends to make a big deal whenever an inversion occurs as sources want to position themselves as the first to break the news. The fact that inversions get so much attention is also part of the reason why an inversion is often associated with an impending recession even if this isn’t always the case.
Why Yield Inversions Don’t Always Lead to a Recession
An inverted yield curve doesn’t necessarily mean that a recession is coming because the stock market doesn’t represent the economy as a whole. Instead, it simply represents the health of the companies that make up a particular index or sector of the economy.
If you have lived through a recession, you know that you’re still going to buy certain items like food, gas and medicine. Therefore, companies that make food, drill for oil or provide health services are generally going to be resilient through a recession. Ultimately, they may still be worth buying even if the broader economy is suffering.
In addition, it’s incredibly difficult to predict what a person is going to do during any given time period. For instance, since 2020, consumers have spent a significant amount of money on services despite the fact that rent and healthcare costs have gone up significantly over the past few years.
This spending has helped to buoy the economy, which means that a recession isn’t set in stone in the next year or so despite the inverted yield curve. Consumers have been able to spend in large part because of hikes to the minimum wage in many states, which have helped to increase wages for other workers.
Ultimately, government and corporate policies will dictate how the economy performs regardless of what any technical indicator says. There are also so many other variables that impact the performance of a market that it’s impossible to assume what might happen several months from now let alone several years from now.
Time In the Market Trumps Timing the Market
Historically, indexes have returned about 10% per year even taking recessions and other poor years into account. Therefore, your aim should be to have as much time in the market as possible if your goal is to maximize returns.
Graph by Slickcharts.com
Many hedge funds now diversify away from equity markets by purchasing alternative assets like real estate, commodities or shares in startups. These investments often have little or no correlation to the stock market, which means that you have the potential to make money regardless of what the economy is doing.
In fact, periods of lower interest rates might actually be a great time to buy real estate as lower rates can result in reduced mortgage payments. You may also be able to find properties at below market value rates that could significantly increase in price when the economy recovers.
The Inversion May Already Be Priced In
Hedge fund managers are not stupid, they know that when the yield curve is inverted, it signals that a recession may be coming. Therefore, they may already demand better prices for whatever investments they choose to make. This means that asset prices may already reflect market conditions.
Working with a company such as Fund Studio can make it easier for hedge funds to make educated decisions about their investments and risk profile. Fund Studio offers risk assessment and other tools so that your fund can be prepared for whatever market conditions exist tomorrow. For more information, get in touch: https://www.fundstudio.com/RequestDemo.aspx.