What Is an Inverted Yield Curve?

Investopedia discusses the inverted yield curve.

An inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.

Historically, inversions of the yield curve have preceded many of the U.S. recessions. Due to this historical correlation, the yield curve is often seen as an accurate forecast of the turning points of the business cycle. A recent example is when the U.S. Treasury yield curve inverted in late 2005, 2006, and again in 2007 before U.S. equity markets collapsed.

Normally, bond investors demand a higher interest rate for locking up their money in a fixed-rate instrument for longer periods of time. Right now they are willing to purchase five, ten, and even thirty-year Treasuries at lower rates of interest. This means that these folks believe that interest rates will be lower in the future and will stay low for a long time. If the economy tanks along with the US stock market, the Federal Reserve will most-likely lower interest rates.

Japan: An Example of Long-Term Low Interest Rates

Normally, we would not think that rates in a major economy would remain low for years or even decades. But, one only needs to look at Japan. In the 1970s and 1980s, during Japan’s boom times, rates ran between 4% and 9%. By the late 1990s, their rates ran between 1% and 0% with brief periods of negative interest rates. (Trading Economics)

Will Inverted Bond Yields Cause Your Investments to Crash?

The first part of this question has to do with how often inverted yields have preceded a market crash and/or recession and by how many years. Is this really a reliable indicator?

Accuracy of Inverted Yields as an Indicator of Recession and Market Correction

Reuters writes that this is a countdown to recession.

The U.S. curve has inverted before each recession in the past 50 years. It offered a false signal just once in that time.

So, this is a pretty reliable indicator that economic troubles are ahead. But, how long will it take after yields invert before the economy and stock market tank? The yield curve inverted in 2005 and again in 2007. Although the 2007 yield curve inversion immediately preceded the Financial Crisis, the 2005 inversion preceded it by slightly more than two years. The thing to avoid here is to believe that the 2005 inversion was a “false alarm.” Long term bond investors are a cautious group. As such, they may sniff out economic trouble and make smart decisions with their bond purchases while everyone else is happy buying into a market that is ready to correct or crash. These folks are using the same sort of approach as with applying intrinsic stock value to their stock purchases. Is should be noted that before the dot com crash that Warren Buffet pulled lots of money out of the stock market because he said did not make sense. And today, he is doing the same as we noted in our article, Silent Warning for Investors.

Will Your Investments Survive a Recession and Stock Market Crash?

This is really what the inverted yield curve issue is all about. Last year we wrote about how to invest without losing any money. The argument we made in that article is that part of your investment portfolio should be in vehicles like US Treasuries, AAA corporate bonds, and bank CDS that are protected by Federal Deposit Insurance. In this part of your portfolio, you will forego growth in favor of safety. And, if today’s inverted yields are an accurate indicator of a coming recession and crash, this part of your investments will be protected against devastating loss.

That having been said, are there ways to keep a foot in the market and protect your investments?

Using Stock Options to Protect Your Stock Investments

Last year we wrote about how to use options to protect your investment portfolio. Our suggestion was to consider buying put options on stocks that you believe are in danger of a correction but still have some room to run.

Market Watch also mentioned buying puts in an article about four ways to protect your stock portfolio using options.

When you buy puts, you will profit when a stock drops in value. For example, before the 2008 crash, your puts would have gone up in value as your stocks went down. Put options grant their owners the right to sell 100 shares of stock at the strike price. Although puts don’t necessarily provide 100 percent protection, they can reduce loss. It’s similar to buying an insurance policy with a deductible. Unlike shorting stocks, where losses can be unlimited, with puts the most you can lose is what you paid for the put.

This can be a very effective strategy for those who know how to use it. That includes picking the right strike prices and options expiration dates. Successful use of this approach also includes knowing when to use it and when to avoid the repeated expense of buying new put options when the old ones expire.

Who Will Run the Post Bernanke Federal Reserve?

The current front runner for the position is Janet Yellen who is the vice-chair of the US Fed board of governors. She was also a key player in the development of the quantitative easing program. Yellen moved to the front when previous front runner Larry Summers bowed out in response to expected opposition from Democratic senators. Others with include Donald Kohn who worked at the Fed for forty years and as a governor for the last eleven and vice chairman for four and Alan Blinder who is also a former Fed vice chairman. These folks are all insiders and could well be expected to continue current policies for which they have consistently voted. A dark horse prospect is Stanley Fischer should the President decide to pick someone from outside of the Fed. Born in Zambia, Fischer was a governor of the Bank of Israel and is a highly respected economist. As the anticipated end of bond purchases drives stocks down investors are concerned that a radical change in direction could greatly upset markets and the economic recovery. As such many expect the President to pick the front runner, Yellen. However, there is no reason that the President could not ask Mr. Bernanke to stay on! A decision to delay a post Bernanke Federal Reserve might surprise many but be a comfort to the markets.

Profitable Investing in the Era of the Post Bernanke Federal Reserve

Sound stock investing principles do not change no matter who runs the Fed or who is in the White House. Wise investors look at the intrinsic value of a stock and its margin of safety. A company with fundamentals that predict continued growth is a good long term pick. A company that has a good margin of safety in the form of property, inventory, and low debt will remain strong throughout an economic downturn. In the post Bernanke Federal Reserve era general economic principles will still apply and those who watch closely and do their homework will succeed.

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