The stock market tanked recently, On August 18th, as investors were spooked by a phenomenon called “Inverse Yield Curve” . Here is quick summary of what it is, and why it should matter to you.
What is it? A yield curve plots bond yield (interest rate) to bond maturity. Typically, yields are lower for shorter maturity bonds, and higher for longer maturity bonds. This is because locking in your investment for a longer duration means more risk and volatility, thus requiring a higher return.
However when investors are worried about near-term future, they start investing into safe longer term bonds, bring up their prices, and lowering their yield. Thus the curve inverts, with short-term bond interest rates being higher than long-term bonds. On Aug 14th, yields for bonds with less than 2 year duration, were higher than bonds with 2 - 10 year maturity (image above).
Why it matters? If history holds true, since 1955, a inverse curve is a leading indicator of recession. A recession often follows within 18-22 months.
What else can cause this phenomenon? Feds action can also accelerate this, as seen recently. When Fed unexpectedly cut short-term interest rates on July 31, in response to a slowing economy, fueled primarily by the Trade Wars between US and China, more investors shifted their funds to long-term bonds, thus accelerating the decline of long-term rates.
What should I do Next? Do not panic. The US economy still looks strong with unemployment rates historically low. However, if the trade wars drag on for a longer period, do prepare for an economic downturn. The general wisdom is to play the long game. Invest in fiscally sound companies, with a long term vision, and diversify your portfolio. Keep enough liquidity for day to day expenses, and to buy into the market, when it hits the low. However, I need to read up more on this, to understand how to protect my investment. Watch our for a specific post in future.