Yield Curve Inversion... what???
Disclosure 1: I have received little-to-no formal training in macroeconomics, in academia or otherwise. All I know is what I hear, and what I've read from others in the space. This post is meant to be an exercise in thinking out loud, and hopefully a deeper understanding into what's going on with our market today.
Disclosure 2: If you do not currently have money invested in the stock or real estate market, I urge you to largely disregard this post as noise. As JL Collins put it so well in his Stock Series Part III (skip to section 4), this is 100% foam. Don't forget: we're only buying the beer.
I, like you, am on the email chain for the BiggerPockets Blog, and however many times a week receive an email highlighting a few of the blogs on the BP site that are helping the most people that week. Ya gotta have a catchy headline to win that game, and occasionally a headline sticky enough pops up to follow up on.
One such that caught my attention quite recently was Phil McAlister's excellent (and well titled) March Madness! Yield Curve Inverts and the Fed Throws in the Towel, where in the first line he trumpets
"The Federal Reserve has essentially given up on raising the fed funds rate any further in 2019."
My approach:
Let's take a moment to review what the yield curve is, and what the implications are from a layman's point of view. Because, after all, in this area I'm just trying to learn as I go...
Resource 1:
When in doubt, start at Google: the number one hit comes from cnbc.com, subtitled (appropriately) Here's What It Means.
An inverted yield-curve occurs when long-term debts have a lower yield as compared with short-term debt.
If you drew a line between them on a graph, it would be an upward sloping curve, starting with the 2-year on the left and moving to the 10-year on the right. The higher rate for the longer-term bond compensates an investor for the greater risk that inflation will chip away at the value of that investment over time.
Higher long-term rates reflect expectations that growth will continue. But when the difference between the short- and long-term rates narrows, it’s a signal that people are less certain that growth is here to stay. The yield curve is a barometer of this sentiment.
To summarize the site, check out this awesome GIF showing yield curves from the last 11 months.
The "Inversion" of the curve occurs first in Dec/Jan, and is the bending of what was a linear trend into a U-shaped one: 2 year bonds trading for a higher yield than 5 year bonds, for example.
Resource 2:
Back to that first article I read last month... Phil's March Madness! post.
McAlister brings the argument back to real estate: what are the warning signs of a shift from a peaking market to one on the decline?
He offers several graphs supporting the argument of a softening if not declining housing market nationwide (though, admittedly, not as yet born out here in Tucson). He also offers the following:
As early as last fall, the plan was to raise rates four times in 2019. Now they are signaling no increases. The bond market looks like it is pricing in a cut! Then, on Friday, March 22, the yield curve inverted. This means that the yield on the three-month treasury was higher than the 10-year treasury. This is a sign that investors are becoming very risk-averse. They believe the prospect for generating strong returns on longer term investments is weak. It would be extremely rare for the yield curve to invert without a recession following within a couple years.
Fat Tailed and Happy provides us with this nifty chart and explanation:
Since 1982, there have now been 5 5/3 inversions:
- June 89, recession followed in July 1990 (13 months)
- September 98, no recession.
- August 2000, recession followed in March 2001 (7 months)
- August 2006, recession followed in December 2007 (16 months)
- January 2019, ??????
Bianco Research offers a bit more data via Twitter.
Summary:
Historically speaking, inversions of the yield curve usually (though not always) create a recession within 6-18 months of repeated occurrences.
Is there a counter-argument?
One of the cooler perks of being in the field full time: I have access to a lot of really smart people I can bounce ideas off of. I took our conundrum to Aaron Leal with Movement Mortgage, and he was skeptical of that logic:
A recession is more than likely on the horizon. In my opinion, I believe we will see a recession in 2021, but it will not be driven by an inverted yield curve. It will be driven by the unemployment rate. A high employment rate doesn’t signal that a recession is coming, it’s actually the opposite. When the unemployment rate is at the lowest level and it goes up from that low point, that usually is a sign a recession is on it’s way.
In the newly published Recession Proof Real Estate Investing: How to Survive (and Thrive!) During Any Phase of the Economic Cycle, author and new host of the BiggerPockets Business Podcast J Scott draws attention to and contrasts 3 separate market cycles affecting real estate transactions from one another:
the Business Cycle (7), The Long-Term Debt Cycle (10) and The Real Estate Cycle (14). He offers:
The business cycle is driven by interaction between two main forces: inflation and interest rates [...] (7)
By controlling interest rates, the Fed has the ability to decide whether it’s lucrative to save money; if not, Americans will tend to spend instead... At this point, we see another snowball effect: decreased business profits lead to decreased employee wages, leading to decreased spending, leading to even lower business profits [...] (9)
You might be wondering why I’m going to focus on the business cycle when the other two cycles also affect the real estate market. The answer is twofold:
1. The business cycle happens much more often than the other two cycles
2. The business cycle tends to have a greater impact on the real estate market than the other two cycles. (16)
When asked about the yield curve inversion arguably causing the Great Recession of 2008, Aaron Leal again notes:
The last recession didn’t crash the residential housing market; the residential housing market crash led to the recession. The reason the housing market crashed was due to a ridiculous amount of risky residential mortgage loans. The difference in the housing market today is there haven’t been a bunch of risky loans originated in the past 10+years.
My only advice to investors is cash-flow is key!
Most recently, J Scott weighed in about our current market cycle position (as of March 2019) on the BiggerPockets Episode 311 & BiggerPockets Money Episode 70; both are worth a listen, as well as the forthcoming book and new BP podcast linked above.
In Closing:
Whether you fully grasp the economic implications of it or not, we can all agree this is an anomaly in the cycle. This type of market has been seen before in history, and is considered highly probably that a recession is possible.
And to borrow a quote I've used before:
What can you do about it?
1) Plug into BiggerPockets and your local REIA. You can find a directory here via National REIA.org.
2) Buy the newest BP ebook available here, and join the community expanding into J Scott's brand new podcast.
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