HOW TO POSITION YOUR PORTFOLIO WITH AN INVERTED YIELD CURVE



An inverted yield curve is when shorter-term bonds are yielding more than otherwise comparable longer-term bonds. This is not a normal condition because investors typically demand longer-term bonds to pay a higher interest rate to compensate them for a longer period of credit and interest rate risks before they can be paid back in full (at par). An inverted yield curve normally signals inflation is a market concern. The Federal Reserve (Fed) has effective tools to control the short end of the yield curve. Currently the Fed is in a Quantitative Tightening (QT) mode, i.e., reducing money circulation and supply, as it attempts to bring the inflation rate back to its target range of 2.0 – 2.5%.


As the Fed continues to tighten the money supply, we have seen rates throughout the yield curve rise, although more so on the short end of the yield curve. This causes a decrease in the prices of bonds. Bond yields and bond prices have an inverse relationship. This rising interest rate environment will continue until we reach what the market considers equilibrium, interest rate stabilization which causes inflation to decrease. When this occurs, it will cause the entire yield curve to normalize. As this occurs, typically we will see short-term rates falling faster than long-term rates. This creates investment opportunities for investors willing to accept this interest rate risk with the goal of generating capital gains when interest rates decline.


There are always opportunities in every market cycle, although there are corresponding risks to consider. In a rising interest rate environment, a conservative investor will want to move down the yield curve to shorter bonds to decrease the interest rate risk and to capitalize on the higher yielding securities. Whereas an aggressive investor believes short-term bonds may mature prior market equilibrium is reached, i.e., senses the inverted yield curve is abnormal and expects this condition to have a short or mid-range timeline before reversion. With that mindset an aggressive investor will typically start dollar cost averaging into longer-term bonds locking in higher rates knowing that these bonds will receive a greater price appreciation which in turn will generate capital gains as interest rates eventually fall. The aggressive investor can afford to accept this short-to-mid-range volatility while anticipating bond price appreciation as the yield curve works its way back to its normal state.


Fair and free markets are made up of buyers and sellers, each of which have what they believe to be rational investment objectives, risk appetites, and time horizons. Before any investment is made, each investor needs to understand their own situation or seek the help of an investment advisor who has years of investment experience in various market cycles.

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