Last month, a funny thing happened: the yield on a 10-year US Treasury obligation dropped below the yield on a 3-month Treasury obligation. This bizarre financial market event attracted a lot of attention, even in the mainstream press, because such “yield curve inversions” have historically been correlated with economic recessions. Given the length of the current economic expansion and the reckless mismanagement of the economy, many people leapt on the inversion of the yield curve to predict that our next recession is visible on the horizon.
Gambling is fun, so if you want to gamble some money on the ability of the yield curve’s shape to predict economic growth, you have my blessing, not that you need it. But due to my unfortunate literal tendency, I have a different take.
An inverted yield curve means you’re not rewarded for patience
A US Treasury obligation’s yield (bills, notes, and bonds) is traditionally decomposed into several pieces: the real interest rate, expected inflation, and what’s often called a “duration,” “maturity,” or “term” premium. That last component reflects the fact that if you buy a long-term bond at a given interest rate and economy-wide interest rates rise, the price of your bond will fall so that its interest rate matches the economy-wide interest rate for comparable bonds. To compensate for those price fluctuations, long-term bonds should offer higher interest rates than short-term bills; otherwise people would only buy short-term debt, knowing they can always reinvest their principal at maturity at the prevailing interest rate.
One reason an inverted yield curve is interpreted as a predictor of a recession is that it implies falling inflation or falling real interest rates, which most often occur during recessions when firms experience downward price pressure and the Federal Reserve cuts interest rates in order to stimulate the economy. If markets predict lower real interest rates or lower inflation, then they’ll be unwilling to lock in today’s nominal interest rates for longer periods, believing they’ll be able to buy the same nominal return at a lower price in 3, 6, or 12 months.
I do not know what is going to happen to interest rates, inflation, or economic growth, and have no opinion whatsoever on the ability of the yield curve’s shape to predict those values. My view is much simpler: if you are not being paid to take on the risk of investing in long-term securities, don’t take the risk of investing in long-term securities!
If you’re not being paid to be patient, then get impatient
I mostly don’t believe in investing in individual stocks and bonds (unless you’re gambling which, as mentioned above, is extremely fun and 100% fine by me), but you can glance at a list of Vanguard mutual funds and get a decent sense of what kind of return you can expect over the ultra-short-, short-, medium-, and long-terms. As of April 9, 2019, these Vanguard funds earned the following SEC yields:
- Prime Money Market: 2.45%
- Short-Term Treasury: 2.33%
- Intermediate-Term Treasury: 2.32%
- Long-Term Treasury: 2.81%
These are the objective facts. The question is, given these facts, do you have any alternative investment opportunities that will yield more over the relevant timeframes? I think you probably do. My go-to resource for these things is DepositAccounts.com. They’re owned by lendingtree, which is a loan origination affiliate company, but so far DepositAccounts doesn’t seem to be corrupted, as long as you ignore their “sponsored” account suggestions.
For short-term savings, you can take advantage of Consumers Credit Union, Orion FCU, and One America Bank, which have certain deposit and transaction requirements but earn between 3.5% and 5.09% APY.
For intermediate-term savings, you have a range of options: Andrews FCU is offering 3.05% and 3.45% APY on 55-month and 84-month certificates, respectively; Sallie Mae, Freedom CU, and WebBank have competitive interest rates on other terms. These products allow you to lock in those higher rates even if rewards checking accounts radically drop their interest rates in the face of a new recession or interest rate environment.
But for longer-term savings, you have a real problem. Investing in long-term securities exposes you to all the risk of rising interest rates, but pays you a negligible amount for the privilege.
How do you invest for the long term in a world without a term premium?
There are, I think, three ways to realize above-average long-term returns on your savings in a world where long-term savings don’t yield above-average returns.
- Reduce your exposure to long-term debt. If an inverted yield curve is telling you that long-term debt is too expensive, then sell it while it’s expensive. Whether you move to cash, equities, or anything else, when the market is screaming that your assets can fetch more than they’re worth, take the market’s word for it and walk away.
- Pay down debt. I have a somewhat different take on debt than many folks in the travel and finance hacking community, since I love negative-interest-rate loans, but it’s indisputably true that if you have a mortgage or other long-term debt with an interest rate above what you can earn on debt with a comparable term structure, paying down the debt is likely the highest and best use of your savings. In other words, if you’re paying 5% on a 30-year mortgage and the potential to earn 3% on a 30-year Treasury bond, you’ve got a pretty easy decision to make.
- Start a business. Remember, the reason the Federal Reserve has kept interest rates at such low levels for so long is for the simple reason that the Board of Governors wants your public sector investments to earn as little as possible, so that you will sell everything and start a business. That window is still open, as I’ve tried to explain in this post, but it’s rapidly closing.
These are not predictions. I have no idea what it “means” that the yield curve is inverted, except that it means long-term debt is not offering a term premium over short-term debt. As far as I know, the yield curve might stay inverted for the next 500 years. But what I do know is that while the yield curve is inverted, long-term debt is at a rare disadvantage compared to short-term debt, accelerated debt repayment, and business investment. This isn’t a theory or a coincidence: it’s the definition of a situation where the Federal Reserve would strongly prefer you do literally anything else with your money than buy long-term government securities.
So, take the hint!