The stock market has felt brutal the past several weeks, no doubt about it. The widely-reported point swings on indexes like the Dow and NASDAQ seem eerily reminiscent of the 2008 Financial Crisis, so it's natural to be concerned. This is all a bit overhyped by the media, but that goes with the territory.
We've been reviewing definitions to key finance terms lately, but with the stock market going through another manic phase, I wanted to address some of your concerns. I'll do so by presenting a few graphics and then explaining the significance of each.
While there are any number of risk factors to consider, let's review one that came up in the media last week – inverted yield curves. You may recall prior posts where we discussed the yield curve and its importance as a recession indicator. Short of rewriting those here, this is one of those areas of finance that's not intuitive and the details get pretty wonky, so please let me know of any specific questions.
The gist of monitoring the yield curve has to do with its near-perfect ability to predict an impending recession. When the yield curve "inverts" (when short-term bonds yield more than long-term), this signals risk aversion, declining business and personal investment and, ultimately, a slowing of the economy typically leading to recession.
Investors monitor several different curves, but the most important are the difference in yield between the 3mo and 10yr Treasury bond, and the 2yr and 10yr Treasury bond. Those curves are "flattening" (the difference in yield is getting smaller) but are not yet inverted. They can stay flat for a long time and inversion isn't a forgone conclusion. But last week the less important 2yr and 5yr Treasury curve did invert and caused a bit of a stir.
Some members of the media took this news and ran with it, implying that a recession was right around the corner. What they didn't say was that the curve in question isn't as good an indicator and that the more important curves hadn't yet inverted. This seemed borderline irresponsible and helped stoke the volatility fires last week.