From Ken Little,
Your Guide to Stocks.
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The yield curve is inverted! The sky is falling! The sky is falling!

Sorry, I couldn’t help the children’s story reference – one that followed me through out my childhood.

You may not know what the yield curve is and don’t know whether being inverted is a good thing or not.

First, let’s look at what it is, then see if it means anything to the average investor.

The yield curve describes the relationship between long and short term Treasury interest rates. In normal times, interest rates on short-term debt are lower than those on long-term debt.

This makes sense if you think about the risk that long-term lenders take. The longer a debt extends into the future, the more bad things can happen that will affect the lender’s return.

You can see this phenomenon in action at your bank. A regular savings account pays a few percent interest, while a five-year certificate of deposit pays quite a bit more.

In this case, you are lending money to the bank and receiving interest.

That’s the way the curve is suppose to work – lower interest for short-term debt and higher interest for long-term debt.

However, things sometimes get out of alignment. The Fed has been raising short-term interest rates (13 times), but long-term rates have not increased at a corresponding pace.

Lower Rates

The result is some long-term rates are lower than short-term interest rates, thus the inverted yield curve.

This odd relationship may reflect investor sentiment that they lack confidence in the short-term prospects for the economy. Some economists and market watchers believe an inverted yield curve signals an approaching recession.

Does an inverted yield curve signal a recession? Sometimes, but not always.

Predicting what the economy is going to do is much like predicting the weather – forecasters can do a decent job over the very near term, but the farther out they go, the higher the error factor becomes.

Conclusion

Your best position, regardless of whether there is a recession or not, is a well-balanced, diversified portfolio.