I do not mean to imply that we have nothing to worry about. But a negatively-sloped yield curve should not be on top of our worry list.

News stories have increasingly focused in recent months on the possibility of a global recession. European economic indicators suggest a dramatic slowdown in economic activity, and worries about Brexit have dampened consumer and business sentiment. Trade disputes have led to competitive tariff increases and fears that a lack of resolution will further dampen global growth. While economic activity remains solid in the United States, one well-followed predictor of future decline has been flashing red. The yield curve has inverted recently with short-term interest rates higher than long-term rates. Such interest-rate patterns have frequently been followed by recessions, and many pundits have suggested that soon the U.S. economy will falter and fall into a recession.

What is the economic intuition behind the alarm that an inverted yield curve signals a recession? One strong influence on the shape of the yield curve is investors’ expectations regarding the course of future interest rates. Suppose the curve was ascending, with long rates higher than short rates. Investors would not necessarily prefer long-term bonds to shorter securities despite their higher yields. If rates do rise in the future, bond prices will fall, and the longer the maturity of the bond, the more its price will decline. Thus, it is often the case that positively-shaped yield curves predict higher future rates.

Alternatively, suppose the curve inverts with short rates higher than bond yields. Investors might still prefer to be invested in long-term bonds despite their lower yields. If rates do fall, bond prices will rise to reflect the lower interest rates. The investor in short-dated bonds would be faced with reinvesting the funds at lower interest rates. Thus an inverted curve tends to be associated with periods when investors expect interest rates to fall. 

This perception explains why an inverted curve could be a harbinger of a future recession. Consider the period 2006-2007, prior to the global financial crisis. The Federal Reserve had pushed short-term rates well above long rates as it struggled to rein in the housing bubble. The inverted curve correctly predicted that the Fed would be successful in dampening the economy and that rates would fall in the future. The inverted curve correctly predicted both lower future rates and lower economic activity.

It is always difficult to say that this time is different.

Nevertheless, we need to consider that our globalized financial markets might make interpreting the yield curve more difficult. Sovereign interest rates across the developed world are close to zero and even negative. Last month, Germany sold a 20-year bond at a negative interest rate. These yields have made U.S. Treasury long-term bonds extremely attractive to international investors, especially since the dollar has been rising in value. Low long rates in this environment may emit a different signal than has been the case in the past.

I do not mean to imply that we have nothing to worry about. The trade and currency war that has erupted could lead to an implosion of the stability of the global trading system. Moreover, such a negative shock would have a disastrous effect on business confidence and could certainly lead to a recession. But a negatively-sloped yield curve should not be on top of our worry list.

We know that neither economists nor Wall Street forecasters have an enviable record predicting recessions. As Paul Samuelson once quipped,

“Economists have predicted nine of the last five recessions.”

But suppose you were convinced that a recession is inevitable and is coming soon. As an investor, what should you do? The best defenses we know to help stabilize the long-term effectiveness of our portfolios are diversification and rebalancing. Diversification ensures that we hold several asset classes in our portfolios and that some classes (such as fixed income) actually produce higher returns during a recession.

Rebalancing can also dampen portfolio volatility. During a period such as the dot com bubble early in the century, rebalancing techniques took some money out of the equity portion of the portfolio and distributed the funds into other asset classes to prevent the portfolio from becoming overly risky and straying from the investor’s risk tolerance. Wealthfront portfolios automatically do both of these things: They are broadly diversified and periodically rebalanced.

There is, however, one action an investor should certainly not take: That is to try to time the market and convert the portfolio to cash in the hopes of reinvesting after prices decline. No one can consistently time the market. And those who do try are more likely to do worse than those who stay the course. They typically panic and sell when times are bad and get back in only after the market has risen and things look rosy. As Warren Buffet has admonished: “The best time to buy is when everyone is fearful.” There is abundant empirical evidence that investors who move in and out of their investments do appreciably worse than those who stay the course. The current environment provides many reasons to worry. But the best advice is: Don’t do something, just stand there.

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About the author(s)

Dr. Burton G. Malkiel, the Chemical Bank Chairman’s Professor of Economics, Emeritus, and Senior Economist at Princeton University, is Wealthfront's Chief Investment Officer. Dr. Malkiel is the author of the widely read investment book, A Random Walk Down Wall Street, which helped launch the low-cost investing revolution by encouraging institutional and individual investors to use index funds. Dr. Malkiel, also the author of The Elements of Investing, is one of the country’s leading investor advocates. View all posts by