What’s the Yield Curve and How Can It Help You Recession-Proof Your Investments?

by | BiggerPockets.com

BiggerPockets Publishing recently released my fourth book, Recession-Proof Real Estate Investing. My goal in writing the book was to teach investors how the economy works, how economic cycles work, and how to use this information to modify investing strategies and tactics to ensure they maintain profits and minimize risk under any economic condition—not just during recessions.

That said, these days, there’s a lot of discussion about when the next recession is going to hit and how we can prepare for it. Those are big questions!

I can’t address all of it here, which is why I wrote the book. But I can highlight a particularly important aspect of economic forecasting, one that can be used to help predict how close—or far—we may be from the next economic downturn.

Different Methods of Economic Forecasting

There are three methods of forecasting that can be used to better understand where we are in the economic cycle and how close we may be to a significant economic shift:

  1. Timing
  2. Observation
  3. Economic Data

I’m a numbers guy, so to me, economic data is by far the most interesting. There are dozens of pieces of data that can be used to assess when an economic shift might occur.

But one, specifically, has proven to be the most reliable over the past 60+ years. It’s called the yield curve.

What is the Yield Curve?

The yield curve represents the change in interest rates for government bonds of different expiration dates. To make sense of what this means, it’s important to understand two facts:

  1. First, the U.S. government sells bonds (a form of debt) to raise money to fund itself. Investors purchase these—they’re called treasury bonds—and in return, they receive a fixed amount of interest.
  2. Second, treasury bonds have various expiration dates, which indicate how long an investor needs to hold the bond in order to receive the maximum return. Short-term bonds expire anywhere from a month to a couple years after purchase. Long-term bonds can expire up to 30 years in the future.

When you buy bonds that expire quickly, expect that you’ll generally get a lower return than if you bought a similar bond with a much longer expiration date. This is because being a long-term bondholder is considered an opportunity cost for an investor. They’re sacrificing using that money for potentially better investments for the duration of the bond.

What Does the Yield Curve Look Like When the Economy is Healthy?

In a healthy economy, there’s a vast difference in the return of short-term bonds versus the return of long-term bonds. On any given day, if you were to plot different expiration dates along with the amount of interest each pays, your graph would start low to the left and end high to the right.

For example, here’s data from January 2004, during a time of strong and vibrant economic expansion:

yield curve economic data from January 2004

The plotted points indicating the bond expiration dates and their associated interest rates is the yield curve. (“Yield” is just another term for interest, especially when referring to the returns that bonds pay.) Bond yields change daily, so the yield curve changes each day, too.

The curve above makes sense. For those people who are willing to invest their money for longer periods of time, the government provides higher returns.

But the government doesn’t actually control the returns on these bonds. It’s simply a matter of supply and demand.

The more investor demand there is for a specific bond, the lower the yield drops. And when there’s low demand for a specific bond, the yield rises.

Yep, you read that right. For in-demand bonds, people are willing to accept lower returns. The opposite is true when there is less demand.

What Does the Yield Curve Look Like Pre-Recession?

As investors grow wary about the economy, they start to move money out of other investments and into long-term bonds for longer-term security. They don’t want their money in real estate or the stock market, because they are concerned about where the values are heading. In contrast, government bonds seem safe and promise a fixed return.

So, in economic periods like these, increased demand for bonds reduce the yield of long-term bonds. At the same time, the desire for long-term security prompts investors to move money out of short-term bonds. Therefore, lagging demand for short-term bonds increases the return on them.

When short-term bond yields increase and long-term bond yields drop, the curve flattens.

This is what the yield curve looked like in March 2006, about 18 months before the Great Recession started:

yield curve based on economic data in March 2006

It turns out that the yield curve is one of the best predictors of an impending recession. Right before one hits, it typically transitions from flat to inverted, meaning the the left and right ends of the curve will be higher than the middle.

Here’s what the yield curve looked like just a few months later in August 2006, about a year before the Great Recession began:

yield curve of economic data from August 2006

With only two exceptions since 1959, any time the yield curve has inverted, a recession has followed. The inversion typically occurs between six and 18 months before the downturn becomes evident.

So, where are we today with respect to the yield curve? More on that and what it portends for the future of the market next time!

Prepare yourself to take any recession in stride! After reading this e-book, you will never be intimidated by a market shift—and you’ll never look at your real estate business the same way again. Pick up your copy today!

Does this make sense? Do you have any questions?

Comment below. 

About Author

J Scott

J Scott is a full-time entrepreneur and investor, living in the suburbs of Washington, D.C. In 2008, J and his wife, Carol, decided to leave their 80-hour work weeks in Silicon Valley to move back East, start a family, and try something new: real estate. Since then, they have bought, built, rehabbed, sold, lent-on, and held over 300 deals, encompassing over $40 million in transactions. J also runs the popular website 123Flip.com, is an active contributor on BiggerPockets.com, and is the author of three books on real estate investing. His books, The Book on Flipping Houses and The Book on Estimating Rehab Costs, have sold more than 100,000 copies in the past five years and have helped investors from around the world get started investing in real estate.

8 Comments

  1. Jason Huff

    Is there anything noteworthy regarding where the inverted curve lies on the y-axis? In August 2006, the inverted curve hovered around 4.8-5.2%. Today, the inverted portion (1 yr to 5 yr) hovers around 2.5%. Just curious whether this indicates an additional wrinkle in the analysis.

  2. Matthew Edwards

    This is a very interesting, and the main practically useful article not only for financiers but even for all ordinary people. The author was so kind that he gave the information so simply that it became even clear to me. I realized that if I see the third curve (Income curve, August 2006), the curve looks like a ship, this crisis will obviously be tomorrow, and if the second (Revenue curve, March 2006) crisis will be in six months, and if the curve ( Income curve, January 2004) grows at an angle of half the angle of 90 degrees, the crisis may not happen. At the University I was a cool student and even studied well! Although I had a sports scholarship and exhausting workouts for 2 hours a day, I had good grades. But I did not succeed in an essay on economics and I used the Internet service of writing an essay. On the internet were many different internet writing services and I selected PapersOwl. I found economic tasks, recession 2006 and everything that I needed after. I selected the terms and pages volume. The keywords were needed for me to order my essay properly. PapersOwl prices were slightly higher other custom writing services only. I ordered an essay about $250 (10 pages&72 hours because short term essay had higher prices). I’ve used the live chat feature next time it was more speedy. As the result I received complicated text I couldn’t understand: “The entire global yield curve was inverted for the first time since the period immediately preceding the beginning of the financial crisis”? and “the spread between the yield of the array of bonds, the maturity of which varies from 7 to 10 years, and the yield of the array of bonds that are extinguished after 1-3 years, went into negative territory this week, and this happened for the first time since 2007.” I was very surprised my essay received the highest mark! But only now I understand I can research my future in a simple way, thanks to the author!

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