What does an inverted yield curve mean?
The yield curve and its recent inversion have received considerable media attention of late. In this article, I will explain the concept, what it really means and how it impacts investment markets.
The first step is to understand that a yield curve is simply a line that shows the interest rates payable on bonds for different time periods. The yield curve that is the current focus is that of US Treasury Bonds which shows the yields (interest rates) for periods of 2 and 10 years.
Typically, the yield curve slopes upward to the right as investors receive a premium (higher interest rate) for bonds of a longer period. This means, that the yield on 10 year Treasuries should be higher than the yield on 2 year Treasuries. This is the same concept as being paid a higher interest rate (yield) on Term Deposits. An inverted curve slopes downwards to the right. The image below demonstrates various yield curves.
Why all the fuss?
Inversions, particularly those that are sustained, are unusual. When the yield curve inverts, it implies the Fed expects a higher risk of inflation than bond traders and these traders or ‘the market’ believes that inflation will actually fall and a recession will occur.
Recently, the rate paid on 2-year Treasuries was greater than that of 10-year Treasuries and the theory goes like this; yield curve inversion means there will be a recession which means the stock markets will crash.
The is supported by the fact that every yield curve inversion since the 1950s has led to a US recession.
Is it really that certain and what is the timing?
This is where the theory struggles, as it is only a theory and not a certainty.
There is a difference between a correlation and causation. By this I mean that yield curve inversion, recessions and sharemarket falls do occur together sometimes – they are correlated. However an inversion does not cause a recession or market to fall.
Not every yield curve inversion leads to a recession.
The average time between inversion and the start of a recession and stock-market falls varies greatly. The average time from inversion to a recession is 19 months. Again this is the problem with averages and trying to rely on them as predictors. The range that creates that average is from a few months to almost 3 years!
Another point is worth mentioning. The US Federal Reserve (Fed) sets the very short term interest rates, which gives us an ‘official’ view of how the Fed sees the economy and the need for support by way of interest rate reductions. At the longer end of the Bond investment, the Bond traders control the rate. It is their view, not a fact.
Whilst you can be correct in making a prediction, taking action early means you can lose money in doing so. When investing, being early and being wrong are the same thing in some cases.
What can we learn from the latest inversion?
It is clear that the economic outlook is not good. As I’ve said before, lower interest rates are used when the economy needs support. Rates both long and short term are at historic low levels. The Trade War between the US is getting worse and is expected to have a negative impact on economic growth.
Most countries have more debt than ever before and the likelihood of it being repaid or at least reduced diminishes every year. If (when) interest rates increase the problem compounds.
To have greater confidence about the next phase, the inversion needs to be more persistent. Let's see how long this one lasts.
What does it mean for Sharemarkets?
The Global Financial Crisis is a good example to illustrate a possible outcome. The US yield curve inverted in December 2005 but share markets continued to rise until late October 2007. In fact, they performed at alarming rates that I wrote to clients in October 2007 warning that the returns were not sustainable and to prepare for falls. If the inversion was used as an indicator to reduce exposure to growth assets, the strong gains available over the period from inversion to the market falls would have been foregone.
Once the sharemarkets began to fall the results were dramatic through to March 2009.
The reality is that, as I have said before, the timing decision is impossible to get right on a consistent basis.
How to respond
The correct way to view the inversion is that it’s really just a signal that economic growth is expected to slow and a signal that more difficult times may be coming and there may be a recession.
It is not the only signal or factor and currently, the US-China trade war is as equally important and possibly more so. If we see positive news on this front, the markets will respond positively. If we don’t, we have a tough period ahead.
Volatility is increasing. We are seeing more frequent, larger movements in financial markets on a regular basis.
Our portfolios are each positioned and are responding according to their approach and return targets. The DMG Diversified Portfolio has slightly reduced exposure to growth assets.
The Clearwater Dynamic Portfolio is using the volatility and falls as opportunities to enter growth assets at lower entry points.
If you are having difficulty tolerating the volatility please contact your adviser to discuss how you are positioned overall and how the expected falls will impact you and if appropriate make changes.