To fight the decades-high inflation of 2022, the Federal Reserve (Fed) began raising interest rates last year. This increase has translated to higher interest rates on fixed-income investments like bonds, but it's going against conventional U.S. yield curve logic.
The U.S. yield curve is a graph that shows the interest rates of U.S. Treasuries over a different range of maturities. Generally, the yield curve slopes upward to the right. The longer a bond's maturity date, the higher the yield it earns. Currently, that isn't the case, as the Fed has boosted short-term rates (four weeks to 52 weeks away) to over 5%, while longer-term bonds (at least 10 years) sit in the 3% to 4% range as you can see below.
Source: www.ustreasuryyieldcurve.com. Data as of July 18.
This is counterintuitive to how investments should work. Why would an investor choose to lock up cash for decades to earn a lower rate than had they bought a Treasury bill that matures within a few months to a year? They probably wouldn't. And that's why some economists are worried about what it signals in regards to a potential recession.
What does the inverted yield curve say about the economy?
While higher interest rates are good for fixed-income investors, it has not-so-great implications for the U.S. economy. According to research from the New York Federal Reserve, there's over a 67% chance of a recession by June 2024, given the current yield curve.
The current inversion of the U.S. yield curve hasn't been this steep since the 1980s, which is unironically when inflation was as high as it was in 2022. Is this recession predictor foolproof? Of course not. However, recessions have happened with much lower probabilities based on the yield curve, and other macroeconomic indicators don't have as strong of a correlation.
Still, other monetary policies and economic factors play a role in determining the economy's direction.
Investors should focus on controlling what they can control
Despite warning signs from this major indicator, it's critical for investors to keep a long-term mindset when investing.
It's true that during recessions, sectors like utilities, healthcare, and consumer staples tend to do well because those companies provide services and products that sell regardless of economic conditions. The opposite is also true for sectors like consumer discretionary and financials.
Even with that in mind, it's important not to deviate from your core investing plan as a reaction to fears of a recession. It can be tempting to switch up your portfolio in an attempt to time the market, but that's often counterproductive. There's nothing wrong with making slight adjustments, but focusing on things you can control should be the priority.
Recessions have been and will continue to be a natural part of the economic cycle. Since the 1948 to 1949 recession, they've happened about every six years. If you switch up your portfolio and investing strategy every time recession fears are lurking, you'll be making frequent changes -- which isn't necessarily good for long-term investors.
Prepare for bad, hope for good
Investors should always want to be informed, but part of this is knowing which information to take to heart, which to consider when making choices, and which to ignore completely. History shows the inverted yield curve is a red flag, but it's not the end-all be-all when it comes to recession predictions, and you shouldn't view it as such.
The U.S. economy post-pandemic has been operating in ways that go against what's found in economic textbooks, so who's to say this time won't be any different?
Regardless of what the future holds, the best thing you can do is make sure your finances are in order. Before making any investment, you should prioritize having an emergency fund (ideally, at least six months' worth of expenses). Once you've established that, make a plan to knock out high-interest debt. Interest owed on debt is guaranteed; there's no guarantee you'll make money in the stock market.
Once you're in a good place to begin investing, don't lose sight of the importance of diversification. For the average investor, it's a must, especially during uncertain economic times.
A truly diverse stock portfolio should include companies with different market cap sizes, growth prospects, geographical locations, and industry classifications. With a diversified portfolio, investors can reduce risks and increase their chances of consistent long-term returns.
