What is an inverted yield curve and why is everyone worried about it?

What is an inverted yield curve and why is everyone worried about it?

The sharp market selloff in the fourth quarter of last year was partially caused by investor concern over an inverted yield curve.  Just last week we saw another big drop as the curve inverted again.  What is the yield curve and why are people worried about it? More importantly, how could it affect your plans if you’re at or near retirement and what can you do to protect yourself? 

What is the yield curve?

When you get a loan, the interest rate you pay is based (in part) on how long you need to borrow the money. All else being equal, the longer you borrow, the higher the interest rate will be.  The same is true when the government borrows.  They pay higher interest on 30-year bonds than on 30-day bonds. If you plot out government bond rates (e.g. 1-year, 2-year, 5-year, etc.) and connect them with a line, that is the yield curve.  In a normal economy, the curve slopes up and to the right, because as we just discussed, rates rise along with time to maturity.  

Why is everyone worried about it?

As we just saw, a normal yield curve slopes up and to the right because long-term rates are typically higher than short-term rates.  Once in a while, however, conditions are such that short-term rates rise above long-term rates.  This is a warning sign that the markets are anticipating trouble for the economy and they expect the Federal Reserve to cut rates.  When short-term rates rise above long-term rates, that graph we talked about earlier shifts from upward sloping to downward sloping.  In short, it becomes inverted.  This is concerning, because it turns out that an inverted yield curve is a pretty good predictor of recession.

Does an inverted curve guarantee a recession?

Not every inverted yield curve has led to a recession, but every recession we’ve had since World War II has been preceded by an inverted yield curve.  So when the yield curve inverts, it’s worth paying attention to.

Is the yield curve inverted now?

The yield curve flattened for most of 2018 as the Fed raised short term interest rates and long-term rates stayed low.  Then, during the fourth quarter, portions of the yield curve inverted.  It wasn’t entirely inverted, but even having portions inverted is a red flag.  Rates normalized a bit earlier this year (and the markets rallied), but last week portions of the curve inverted again when 10-year rates fell below 3-month rates.

If a recession follows an inversion, how long does it usually take?

An inverted curve is a good predictor of recessions, but they generally don’t happen right away.  The average time between inversion and recession is about a year.  

What does the stock market typically do after the curve inverts?

Markets will usually continue to rise for a period of time after an inversion.  For example, markets rose an average of 35% after the last 3 inversions (1989, 1998 and 2006), before ultimately falling as the economy went into recession.  And returns on the S&P tend to be above average for many months after an inversion. So yes, an inverted yield curve can signal a potential recession, but it can also signal a period of strong stock returns before the recession arrives.

What should investors be doing?

A yield curve inversion isn’t a perfect indicator and it’s by no means the only economic indicator. There are plenty of signs that point to a strong U.S. economy and as we saw above, markets usually continue to rise for a period of time even after an inversion.  That said, it’s a red flag, as are signs of slowing economic activity in Europe and China.  The best thing you can do is to make sure that you are invested in a way that is consistent with your risk tolerance, time to retirement, goals and overall financial situation.  Then, even if things get choppy, you’ll be able to ride out the storm.  For further ideas on what to do, read: Should you prepare for a deeper downturn?  

Strategies of retirement super savers

Strategies of retirement super savers

The general idea behind retirement is to reach a point of financial independence where work is optional and you control your time.  How fast you get there depends largely on how much you save and how much you need to live on during retirement.  The math is pretty simple.  The more you save and the less you need, the faster you will be financially independent.  How can you ratchet up your savings and reach your goals faster?  For some ideas, let’s look at the habits and tactics of super savers (people who save 30-50 percent of their take home pay).

How to save half your income

First, let’s address the elephant in the room.  “Wait Joe, Did you say 50 percent!?!”  Indeed I did.  That might sound ludicrous to most of you, but let me prove to you that it’s possible.  Think about how much money you make.  Got it?  Ok.  No matter what number you have in your head right now, there are millions of people in the U.S.—some of whom no doubt are your friends, neighbors and co-workers—living on half that.    Say your income is $100,000.  Almost half the country is currently living on half that.  Or maybe your income is $50,000.  There are tens of millions living on half of that.  So living on half of whatever number you have in your head right now is not only possible, it’s apparently pretty easy.  Millions of people are already doing it.  The trick is to spend like them, even though you’re making twice as much.  Do that and your savings rate will skyrocket.  Let’s look at how super savers do it and then consider how to apply those lessons.

Strategies of Super Savers

They focus on maximizing income.  Super savers focus on income, not just expenses.  They realize that the more money they make, the easier it will be to cover a comfortable lifestyle and still have plenty left over to save.

They avoid lifestyle bloat. Most people allow lifestyle bloat as they get older.  As income grows, so do expenses.  Bigger paychecks mean better houses, cars, vacations, wardrobes and gadgets.  If you spend everything you make, you’ll never be financially independent.  Super savers try to buy their freedom as soon as possible by capping their lifestyle and saving the rest. 

They have clear priorities and goals.  Super savers understand what’s important to them and what’s not.  They have clear retirement goals.  They have a vision for their future.  They know what they really want out of life and they are taking those plans very seriously.

They are self-aware and secure.  Because super savers take the time to think about what’s important to them, they are less likely to make purchase decisions based on expectations, peer pressure, vanity, a pushy salesperson or the need to keep up with the Joneses.  Instead, they spend liberally on things that provide them with a solid ROI and miserly on things that don’t.

They make things simple and automatic.  Super savers automate their savings by having the money automatically deducted from their paychecks and/or bank accounts.

They are organized and intentional.  Saving large chunks of your income doesn’t just happen.  In fact, the path of least resistance is to spend everything you make.  Super savers are disciplined and intentional about earning, saving and spending.  They track their progress and regularly try to improve.

They have aggressive goals. I have a theory.  Our collective failure to adequately prepare for retirement is partly due to the fact that our target (mid 60s) is so far out in the future when we start our careers.  There’s no sense of urgency.  Super savers have aggressive goals that don’t allow for complacency. 

They use debt sparingly.  Debt allows you to bring future purchases into the present.  You get the fancy doodad now in exchange for the promise to keep working so you can pay for it over time.  Super savers understand this calculus.  They realize that you don’t add debt, you exchange future years of your life for it.  And since they hold those future years dear and want to control their time, they use debt very sparingly.

It’s not about the job.  For the most part, super savers aren’t trying to quit working.  They’re trying to get to the point where work is optional and they have greater leverage in choosing the type of work or other activities that they do.

How to buy your freedom faster.

I wrote this article, of course, in the hopes that it would inspire some of you to ratchet up your savings rate and thus buy your freedom faster.  Here are a few simple ways to apply the strategies discussed above.

Inventory.  The first step is a quick inventory of your current financial situation.  The goal is to get an overview of how much you earn and where that money is going.  Grab a pay stub and calculate your annual after-tax income.  Make a list of what you’re currently saving in your different accounts (e.g. 401k, IRA, etc.).  Review your budget to see where you’re currently spending.  Again, the idea with this is just to get a clear picture of how much money is coming in and where it’s going.

Define your priorities.  Next, think about what’s important to you.  What do you actually want to do in this life?  When would you like to retire and how much money do you need to fund that lifestyle?  What goals do you have?  What types of purchases do you view as most worthwhile?  The idea here is to define your priorities and goals so you can allocate your resources more efficiently.  You want to invest in things that are important to you and stop spending on things that aren’t. 

Set an audacious savings goal.  How much are you saving?  Nothing?  3 percent?  10 percent?  Whatever the number, set a stretch goal to drastically improve your savings rate.  Something that will give you a sense of urgency and force you to put forth major effort. 

Track. I’ve been experimenting with savings rates myself for the last two years.  To help, I created a simple spreadsheet that has a column for my income, columns for each of my accounts and a column for my mortgage.  Then each time I get a paycheck, I list my after-tax income in the income column and then enter the amount of savings in each of the other columns (e.g. 401k, IRA, HSA, etc.).  I’m trying to pay off my mortgage quickly, so I count extra payments there as savings. 

Reallocate. Increasing your savings rate takes time because the extra money you want to save is already allocated somewhere else.  In some cases, it will be easy to reallocate it.  If you eat out regularly, but that isn’t a high priority, then stop eating out and send that money to savings instead.  Other things take a little more time (e.g. paying off credit card bills) or more effort (e.g. lifestyle changes like downsizing your house).  As you get rid of past indiscretions and reorder your priorities, your savings rate will rise and you’ll reach your goals faster.  Not only that, but you’ll also be less stressed about money and more satisfied with your lifestyle because you’re spending on things that matter to you.

Be Intentional,