Who’s afraid of the yield curve?

Google searches for ‘yield curve’ have grown, but what is it and what is the significance of inversion? Ed Smith explains why US government bond yields have spooked some investors.

The yield curve is all the rage in the financial press, with more people searching for it on Google than at any time since 2005, which was the last time that it inverted. But what is the yield curve? What does it mean for it to invert? And why should we care?

In the US, an inverted yield curve is one of the most reliable harbingers of recession. It’s such a good forecaster, so the old joke goes, that it has predicted 11 of the past nine recessions. But two false signals and no misses is exceptionally good going in the world of financial forecasting.

It’s called a curve because it describes how bond yields typically “curve” up as the time to maturity gets longer. That’s because lenders generally demand a higher yield to compensate for the additional risk of parting with their cash for a longer period of time.

In market parlance, “yield curve” is generally used as shorthand for the difference between the yields on the 10-year and two-year Treasury bonds. A negative reading is referred to as an inversion, and it’s highly unusual. The worrying thing is that it signals that the economy may be overheating in the short run, triggering rate rises that will choke future growth.

Sometimes, it’s measured by the difference between the 10-year and one-year Treasuries — we favour this over the 10- to two-year curve because it’s ever so slightly more stable, but the two are very highly correlated. A little-referred-to part of the curve, the five- to three-year differential, recently turned negative. And judging by those Google trends, it has captured people’s attention.

The five- to three-year curve is also highly correlated to the more commonly cited versions. When the former inverts, so too does the latter (plus or minus a few months). The five- to three-year curve has also sounded the same false signals in the past. History suggests that its recent inversion will most likely be followed by the inversion of its more commonly watched counterparts. Should we be worried?

The problem with interpreting an inverted yield curve is that the length of time between inversion and recession is very inconsistent, and always long. Because of its inconsistency, the yield curve doesn’t give a convincing probability of recession over the next 12 months. This gauge of recession probability read 35 to 40% ahead of the last three recessions. Today’s readings suggest a 19 to 25% chance.


Putting the cart before the horse

It is important to remember that the yield curve is more symptom than cause of a slowdown. It reflects the fact that the economy is in danger of overheating in the near term, and expectations that yields (and returns businesses can expect on their invested capital) will be headed lower over the longer term.

This gap between corporate borrowing rates and investment returns can be estimated more specifically using national accounts data, which, pleasingly, does not yet suggest that the business cycle is nearing its end.

Since the mid-1950s, the yield curve has inverted on average 14 months before a recession. Equity markets only lead recessions by three to six months. Selling equities as soon as the curve inverts could cause you to miss out on rising equity markets for rather a long time. For risk-aware investors, missing out on the final few months of returns is often prudent. But missing out on the final few years may be less forgivable. The last time around it took two years from inversion to recession.

US equities have often continued to post decent returns after yield-curve inversion, especially since the 1980s, although markets seem to get more jittery in the initial three months. Following inversion, less cyclically sensitive sectors have tended to outperform. US and UK equities on average tend to be less sensitive to global economic activity compared with other markets.

So, the bottom line is that history does not suggest that investors should cut equities as soon as the yield curve inverts. But positioning in the more defensive parts of the market may be prudent.

Ed Smith is head of asset allocation research at Rathbones.

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