The Bond Market Just Sent a Big Recession Signal. Here's What to Do

On Wednesday, bond market investors sent one the clearest signals yet that the U.S. economy is teetering on the edge of a recession.

For the first time since the 2007 financial crisis, yields on 2-year Treasury bonds slipped below those of longer-dated 10-year notes. The move, known as "yield curve inversion," has preceded every recession since the 1970s.

Perhaps no surprise then that stock market investors were spooked, with the Dow dropping more than 500 points Wednesday morning.

So should you be worried?

Americans have enjoyed 10 years of essentially uninterrupted growth, and that probably won't go on forever. The Federal Reserve's decision to cut interest rates last month suggests policymakers are also wary.

That said, if you've invested with a smart, age-appropriate mix of stocks and bonds, you should be prepared to weather any downturn.

Here is what you need to know:

What just happened

Early Wednesday morning, the yield on the 10-year Treasury note fell to 1.623%, slightly below the 2-year's yield of 1.634%, according to CNBC.

That's unusual. For investors, buying bonds with longer maturities means tying up your money for longer and, typically, taking on more risk. This is because there's more time for interest rates or inflation to rise, both of which can hurt bond values. (Bond prices and yields move in opposite directions.) To compensate for this added risk, longer-dated bonds typically offer fatter yields than shorter-term bonds.

When the economic future is uncertain, however, that dynamic can be upended.

In times of slow or negative economic growth, interest rates typically remain low. And when investors see those conditions looming on the horizon, they start to see the idea of locking in today's interest rates, which seem comparatively high, as an advantage. As they rush to buy longer-dated bonds, prices rally and their payouts shrink sometimes to surprising levels.

That seems to be what is happening right now. Worries about slowing growth not just in the U.S. but also Europe and China have sent yields on 10-year U.S. bonds tumbling from 2.061% on July 30 to just above 1.6% right now. Events in foreign bond markets have been in some ways even more dramatic. Yields on government debt issued by Japan and a number of European countries have actually turned negative, meaning investors are so desperate to park their money in a safe place they are willing to accept less back than they paid out.

What it means

While no economic indicator is a sure-fire predictor of recessions, the yield curve has proved one of the most reliable. One recent study by the Chicago Federal Reserve found the typical relationship between 10-year and 2-year Treasuries inverted shortly before each of the last seven recessions going back to 1970.

(Other research, which focuses on a slightly different version of the yield curve--the relationship between the 10-year and 3-month Treasuries--also finds a strong correlation with recessions. It's worth noting that that version of curve has been inverted for weeks.)

All this doesn't necessarily mean the U.S. economy will turn south immediately. While research shows a yield curve inversion almost always precedes a recession, there have, occasionally, been false positives when the curve inverted but no recession followed.

What's more, even when a yield curve does predict economic trouble, it can still be months or even years off. A look five historical inversions going back to 1978 by investment firm LPL found that, on average, the stock market did not reach its ultimate bull-market peak for 13 months after the bond market first started sending warning signals.

What you should do

As a long-term investor, your reaction to Monday's news should be the same as it is to any market news: Shrug it off. Your carefully calibrated mix of stocks and bonds is meant to weather just such an event as this.

Remember: Yields on 10-year bonds are falling because those bonds' prices are rising. As the bond portion of your portfolio appreciates, the gains will help offset any losses you suffer in the stock market. Your portfolio is working exactly as it should.

One caveat: If Wednesday's move, or last Monday's 700-point stock market drop, is keeping you up at night, you might consider dialing back the risk in your portfolio. The Dow is still within a couple thousands points of its July record high. It would be a lot better to step back now than in the midst of a recession where you might face locking in losses of 20% or more.

But remember the reason to do this would be to give yourself an insurance policy against your own emotions, not because you think the market might go south.