Economic Metrics – Yield Curve Inversion

Typically, the return on longer-term bonds yields a higher interest rate than that for shorter-term bonds. This makes sense as investors expect to be compensated for the inherent risk and unknowns in holding a longer duration investment. Although various length of bond maturity yields can be compared, the one scrutinized for its historical implications to past recessions is the 2 year vs 10 year treasury bond yields. Under “normal” conditions, the spread or difference between the 10 year note and the 2 year note is net positive. When this spread becomes negative, that usually gets the attention of the markets and investors as it is essentially a proxy for investor sentiment about what the market has in store. If investors feel uncertain that they could achieve higher interest rates on their money returned from a short-term bond when it is returned then they will be more likely and more willing to commit their capital to a longer term with a lower return with the thought that it will ultimately be the best move in the long run.

The 10 year/2 year yield curve inversion is significant in that it has been noted to occur prior to each of the past 5 recessions in the past 50 years. The time period between the inversion occurring and each of those recessions has been variable but on average has occurred about 20 months after the yield curve inversion. If that average were to play out in regards to the yield curve inversion from August 2019, one would expect a recession by April 2021.

What contributes to this relationship between yield curve and recession? One of the primary reasons is because of a shift in the credit availability which puts a hamper on many markets. With this inversion, banks do not have the incentive to borrow money at short-term (higher) rates and loan it out at longer-term (lower) rates and therefore credit availability slows. This could be (and has been) manipulated in the short term by the Fed adjusting interest rates down a bit, but at some point that option fails to be able to support an impending market slowdown or recession.

So what does this mean for real estate investors? I think one of the biggest considerations ties back in to the credit availability issue. Most real estate investors are using leverage to increase their returns. However, one should always be aware of what the terms of such financing obligates them to if market conditions change and selling might be a less desirable option yet they do not have the ability to refinance out of variable term loans secondary to tight credit availability. To mitigate this risk, always consider a longer time horizon than what you THINK you might be holding a property and make sure the finance amount and terms are conservatively manageable for any suspected lulls in the real estate market. Hopefully you are doing those things already, but when there’s more and more talk about the possibility of an impending recession it is always appropriate to take inventory of your positions and make sure you are ahead of things to stay out of trouble.

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