On Tuesday morning most of us woke up to the headline, “Yield Curve Inverts”. Depending on who you follow, the title may have been much more dramatic. Perhaps something like, “Interest Rates Signal Recession”, or so on. What every one seems to understand is simple, when the yield curve inverts, that is a historical signal for a coming recession. Of course, nobody knows how far out that recession may be, it could be months or years. But what is an inverted yield curve? And why would it signal a changing market cycle?

An inverted yield curve occurs when the interest rates (yields, to be more specific) on short-term bonds are higher than the interest rates on long-term bonds. The specific trigger compares the 10 year treasury to the 2 year treasury. How can that happen? Isn’t it investing 101 that the longer the bond’s maturity, the higher the interest rate?

Well, when a yield curve inverts it means that investors have little confidence in the near-term economy and they demand more yield for a short-term investment than a long-term one. It means they are flocking to long-term bonds because they would prefer their money be tied up and safe. As investors flock from short-term to long-term bonds the short-term bonds have to raise yields to attract investors and the long-term bonds can lower yields because they don’t need to attract investors. This is how the yield curve inverts and it’s one way to view investor sentiment.

A yield curve inversion can happen without a recession following, its happened before and right now the Fed has said there is a bout a 35% chance of a near-term recession. What is important to watch now is whether the inversion gets worse or better, especially with new rate cuts potentially on the horizon.

Regardless, we can’t actually predict market cycle timing and because of this we build portfolios to sustain both poor and thriving market conditions. You should do the same as history has proven that attempting to time the market based on these signals is a fools errand.