Don't panic over the yield curve inversion: El-Erian

The U.S. Treasury yield curve inverted Monday morning for the first time since 2007, sending equities into a tailspin and raising concerns about a recession. But strategists including Mohamed El-Erian are sending a message: Don’t panic.

El-Erian, chief economic advisor at Allianz, said there are risks in the economic environment. However, the traditional inversion signal needs to be viewed cautiously.

“I think the traditional signal is not as valid as the distortions are in driving the yield curve,” he told Yahoo Finance’s On the Move.

Inversion of the curve — that is, when the yield on the two-year Treasury exceeds that of the 10-year — has presaged seven of the last recessions. It effectively means investors are more confident about the long term than the short term, as they’re being paid more to take the risk of holding shorter-term government debt.

El-Erian said in this case, there are other factors.

“One, negative rates in Europe. And we've now got $16 trillion of bonds trading at negative yields because of what's happening in Europe. And the second distortion is this unhealthy co-dependence between markets and the Fed,” he said.

That’s all driving investors into the longer end of the curve in the U.S. — therefore depressing the yield in a way less connected to sentiment about the nation’s economy. (Treasury yields move inversely to price).

Even if there is a recession, there are mitigating factors that make it less likely it will be as severe as the financial crisis-era downturn.

“The good news — and there is good news— is one, the source of the big shock in 2008, the payments and settlement system, the ability of people to trust their counterpart, that risk is very low. Central banks learned a very painful lesson in 2008, and the payments and settlement system is very robust,” El-Erian said.

“The second bit of good news is that the banks that transmit shocks are in a good place in the U.S. So you won't get what I call the sudden stop, what people worry about most — the loss of trust in financial markets that then brings everything to a standstill.”

Other strategists point to the strength of the U.S. consumer for reassurance.

“I think the consumer's in a much different place than they were in 2007-2008,” said Brent Schutte, chief investment strategist at Northwestern Mutual Wealth Management. “And if you actually looked at the debt-to-equity ratios on the consumer balance sheet, they've been completely rebuilt to 1985 levels. And the cost of that debt is still very low.”

He suggested that if a recession is coming, it’s not imminent. He is closely watching corporate credit spreads, which haven’t been sending the same negative signal as Treasuries.

Don’t act too fast, just be cautious

Anne Lester, head of retirement solutions at JPMorgan Asset Management, cautioned that investors shouldn’t make portfolio adjustments based on recent volatility.

“The whole notion that one day’s movement up or down is going to make or break your retirement is a complete fallacy,” she said. “It only damages your future income if you sell everything.”

Lester’s team analyzed S&P 500 (^GSPC) returns between Jan. 4, 1999 and Dec. 31, 2018, and found that if an investor missed the 10 best days of performance, the return dropped from 5.62% to 2.01%. In other words, Lester said, it’s tough to try to time the market.

Of course, the current economic and market environment isn’t risk-free. El-Erian highlighted one area to watch.

“Because of the ample and predictable provision of liquidity by central banks for years, the system has promised too much liquidity to the end users. So there are a lot of illiquid pockets in liquid instruments. And that's the mismatch I worry about most,” he said, citing some ETFs as one example.

Bottom line, El-Erian said: U.S. stocks are still a good bet, but investors should be more cautious.

“Do not fade the U.S. trade. In particular, don't be tempted to reduce U.S. exposure in favor of European exposure,” he said. “Some people are telling you to do it. The U.S. is still better off economically.”

If you’re an everyday investor, El-Erian added, “if all you rely on is the public markets, and all you rely on are the broad indices, I think you want to take down risk at this point.”

Julie Hyman is the co-anchor of On the Move on Yahoo Finance.

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