Inverted Yield Curves and Licorice

David Faulk |

Many years ago, when I was about seven years old, my family went on a road trip.  I remember being excited for the journey, but at the same time concerned for the upcoming 10-hour drive.  

In order to make the trip more enjoyable, I spent time earning/saving money so I could buy a couple treats to take with me.  As the trip neared, I purchased my favorite candy, licorice (Red Vines was my brand of choice, for anyone who cares to know).

Shortly after the drive started, I decided to start the licorice party and before too long found that I had eaten the entire package (OK, it was two packages) of licorice.  As we drove over some mountain roads, my stomach informed me that eating that much licorice was a bad idea and I became sick.  This one experience did not deter me from ever eating licorice again, but I found that sometimes I got sick and sometimes I did not

So, what does licorice have to do with inverted yield curves?  Before I tell you, let me briefly describe an inverted yield curve.  Inverted yield curves simply mean the interest rate on short-term bonds are higher than the interest rate on long-term bonds.  Traditionally, we expect long-term interest rates to be higher than short-term interest rates.  For example, if I were to compare the interest rates on a 2-year certificate of deposit (CD) and a 10-year CD, I would expect the 10-year CD to provide a greater interest rate.  After all, I would have to lock-in my money for 10 years waiting for the CD to mature.

Why would the interest rate invert?  Why would short-term bonds/CDs pay more interest than a 10-year bond/CD?  Sometimes this occurs because the “market” feels that the economy is going to slow down in the future (is getting sick) or that the Federal Reserve has set interest rates too high.  One of the many other alternatives may be: when the demand for longer-term bonds are very high, which can cause interest rates to fall (trust me on this – possibly this will be the topic for a future blog post).

As I mentioned above, sometimes the yield curve invert is due to an impending slowdown in the economy, which may result in a recession.  It is important to note that an inverted yield curve does not always signal that a recession is coming.  At Johanson Financial Advisors, we do not know when the next recession will occur, but we know that someday it will (on average a recession will occur every 4.7 years). 

We believe, in part, that the yield curve inverted slightly, because many nations around the world have bonds with negative interest rates forcing the hand of investors to purchase U.S. bonds with their positive interest rates (representing the strongest economy/currency in the world).

The key is to understand that there are many reasons why yield curves may invert.  Just like when I was younger, eating licorice did not always result in me getting sick, so too an inverted yield curve will not always predict a recession.