On Tuesday, 12/4, the yield curve inverted and the Dow Jones Industrial Average sold off nearly 800 points. Several chief market strategists and pundits have reason to believe that this bull market, the longest in history, may soon come to an end. After a volatile few days on Wall Street, a flurry of trade talks, and a speech from Federal Reserve Chair Jerome Powell’s, investors were left apprehensive.

Some Americans are concerned about what this could mean for their investment accounts, and for those who have capital to deploy it’s a particularly choppy water to navigate. This article takes a look at what an Inverted Yield Curve means and how it may impact your portfolio and asset allocation decisions going forward.

Inverted Yield Curve

What’s going on with the Yield Curve? As shown in the chart above from the Federal Reserve, the three-year treasury yields are in excess of the yields available for five-year treasuries. Typically, investors would expect shorter-term notes to pay less than the longer-term notes as investors demand more return for locking away their money for longer periods. Presently, investors are actually requiring the inverse – higher yield for shorter duration (or, put differently, investors have less confidence in the US government’s ability to pay its debts near term compared to the longer term).

What does an Inverted Yield Curve Mean? In the rare instance of an inverted yield curve, investors eschew typical ‘time value of money’ considerations and prioritize long-term security over more immediate cashflow. As mentioned above, the yield curve has been a fairly consistent leading indicator of economic trajectory. The inverted yield three-year and ten-year yield curves that occurred in 1978, 1988, 2000, and 2005-2006, all preceded recessions. It should be noted that this is a correlation and NOT a causal relationship. The inverted yield curve reflects aggregate investor sentiment and tends to function as a leading indicator in a ‘wisdom of crowds’ capacity, but an inverted yield curve does not directly impact the economy.   

What comes next? While it’s impossible to precisely forecast market direction going forward, many investors focus more closely on the difference between two-year and ten-year bond yields (“2-10”). Currently, the spread between the 2-10 is the thinnest on record since the financial crisis. That said, every past 3-5 inversion has been followed by a 2-10 inversion. A 2-10 inversion has preceded every U.S. recession going back 50 years.

What can I do about an Inverted Yield Curve? There’s no need to panic. Historically, there has been a significant lag time between a 3-5 inversion, a 2-10 inversion and a recession. There should be sufficient time to appropriately prepare. That said, historical data indicates recessions last roughly 18 months on average. If investors believe a recession is imminent and investor behavior is consistent with past experiences , the market would experience a general ‘flight to safety’ in more insulated investments for the next several years and an avoidance of short duration treasuries and low-yielding money market instruments.

The current market volatility could present a timely opportunity for investors to consider shifting exposure from public markets to more market-insulated investments like commercial real estate.

A recent Barron’s article explained, “almost every strategy in private capital is sitting on record amounts of money ready to be deployed, looking for something to buy.” According to data provider Preqin, private equity AUM (assets under management) grew 20% year-over-year in 2017 to a record $3.06 trillion, of which, $294 billion is earmarked for real estate. The industry saw a similar pattern leading up to the last financial crisis.

It is important to note that alternative private investments are often locked up with a longer investment horizon. Though no we don’t pretend to know precisely how or when the next economic downturn will take place, the consensus among economists is that  a mild downturn is likely by 2020. Given current volatility in public markets, investors are seeking exposure to private commercial real estate, where illiquidity is attractive in uncertain times.

As you continue to follow the treasury yields and the market more generally, and if alternative investments in commercial real estate are right for you, please have a closer look at EquityMultiple and we encourage you to schedule a call with with our Investor Relations team.

By EQUITYMULTIPLE Staff
EquityMultiple's team features real estate industry veterans, technology-driven analysts, and dedicated armchair economists.
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