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What is a yield curve, and why should I care if it inverts?

Everybody is talking about the inverted yield curve and how it predicts recessions. John Stepek explains everything you need to know about it and why it matters.

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The yield curve has inverted.

To be more specific, the most important bit of the yield curve on US government debt has inverted.

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What do you mean, you still don't know what I'm talking about or why you should care?

An inverted yield curve is one of the more reliable recession indicators out there.

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So strap yourself in for an exciting ten minutes as we reveal everything you need to know about it...

Everything you ever wanted to know about yield curves (probably a lot more in fact)

Saturday Money Morning

But for those of you who don't, here goes.

If you lend money to someone for ten years, you'd normally expect them to pay a higher interest rate than if you loaned the money to them for one year.

That's because you have a better idea of what your money will be worth in one year's time than in ten years' time. You want the added interest to compensate for the added risk.

So, normally, if you drew a line plotting interest rates versus "time to maturity" (the time between when you hand the money over and when you get it back), you'd expect it to form an upward curving slope. The longer the loan, the higher the rate.

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This is the yield curve. You can plot it for any bonds, but in this case we're looking at US government debt (Treasury bonds).

So what's an inverted yield curve? It's the shape you get when short-term bonds pay a higher interest rate than longer-term bonds. In other words, the line slopes down, not up.

Why is this bad news? Well, let's have a think. Assuming there's no credit risk (which is the assumption with US government debt), then why would you ever be content to lock your money up for ten years at a lower interest rate than for one year?

The only sensible answer is that you think rates will be even lower in the future. If rates fall further in the future, you should lock in the rate you can get now. That means that even if you sell before the bond matures, you'll make a capital gain as rates continue to fall.

So an inverted yield curve implies that investors think rates have further to fall. Why might rates fall? Because the economy is going to hit a rough patch, demand for borrowing to expand is going to fall, and therefore the central bank is going to have to "stimulate" activity by cutting rates.

It also implies that inflation will be weak, or that prices might even fall. If you expect deflation, then money in the future will be worth more than money today, which is another reason you'd be keen to lend money for a longer period.

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In other words, an inverted yield curve is an example of the "wisdom of crowds". It means the crowd thinks we're heading for an economic rough patch, also known as a recession.

And while I hate to say it, the yield curve has a good track record.

It's probably not different this time, despite what everyone will say

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Now, you can nitpick about this, but this particular yield curve inversion has happened in advance of the last seven recessions. As John Authers points out on Bloomberg, "stocks often continue to rise after the yield curve first inverts but on average the moment of a yield curve inversion is a bad time to buy stocks."

In other words, it usually takes equity investors longer to get the message, but when they do, they get it good and hard.

Now, you will hear plenty of people saying that "it's different this time". People said that the last time the yield curve inverted and then the 2008 financial crisis happened. They said it when the curve inverted ahead of the tech bust as well. And I suspect they've been saying it ever since people started to pay attention to the inversion.

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So take all the "you can ignore it this time" arguments with a hefty pinch of salt. The yield curve almost certainly knows more than you or I or former central bank bosses do.

So what should I do about this?

Recessions don't always have to be apocalyptic, banking-system destroying, employment-ravaging monsters. Sometimes they're just downturns.

Then again, the financial system looks fragile, to put it bluntly. And the geopolitical backdrop many of us grew up with is changing too. So maybe we could get quite a nasty one, particularly given how expensive most asset classes are.

It boils back down to what I've been saying all week: don't panic. The reason you stay informed about this stuff is so that you can keep calm when everyone starts shrieking about pending recession.

When you're looking at your investments, bear in mind that there is now a good chance that the economic backdrop will become a lot less forgiving in the relatively near future. Can the assets you own cope with that? If they are priced for perfection, maybe have a rethink, because "perfection" is not what we're going to get. But if they offer a sufficient margin of safety well, stick to your plan.

Oh, and do come to the MoneyWeek Wealth Summit in London later this year. Come 22 November, we'll be that much closer to recession and a lot of the big political questions of the day will be closer to being answered (raising new ones in the process, of course). We're gathering some of the smartest experts we know to talk about all the big issues and how they affect your investments. Don't miss it book your ticket now.

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