The yield curve finally inverts

The moment investors have been fearing arrived this week, says John Stepek. But what is a yield curve and why does it matter?

The moment investors have been fearing arrived this week. But what is a yield curve and why does it matter?

It's finally happened. One of the more reliable recession indicators has signalled that a downturn is on its way. Earlier this week, after years of hovering threateningly on the threshold, the US yield curve finally inverted.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

First, let's explain what that actually means. A yield curve compares the yield on bonds (IOUs issued by governments or corporations) that have the same credit quality, but different maturities (the time remaining until the date that your capital is returned).

A healthy yield curve slopes up from left to right in other words, bonds with longer maturities yield more than shorter-term ones. That makes sense for most of us, most of the time, money today should be worth more than the same amount of money in a year's time. So we expect to get paid for waiting.

Advertisement - Article continues below

As the yield curve "flattens" that is to say, the gap between the yield on long-term debt and that on short-term gets smaller it indicates that investors are more hesitant about future prospects. It suggests markets expect future rates to be little changed from current ones, which implies in turn that growth will be mediocre, and incapable of driving inflation and therefore interest rates higher.

Finally, when the curve inverts namely, longer-term yields are below shorter-term ones it implies that investors are very pessimistic. They are happy to lock in long-term yields today, because they expect them to be even lower in the future, which suggests they expect low inflation, or even deflation, which tends to go hand in hand with recessions.

In the US, the yield curve between the three-month and the ten-year US Treasury inverted some time ago. But the big news this week is that the curve between the two-year and the ten-year has also inverted. Why does that matter? Because the same thing has happened priorto every single one of the last seven US recessions, with recession following inversion within24 months. There has onlybeen one "false positive" in that time the curve inverted in summer 1998. At that point, the Federal Reserve under Alan Greenspan undertook a series ofcuts and a recession didn't take place until March 2001.On this occasion, it may not be so easy.

The Fed cut rates last month, but the market deemed it insufficient. Unless we see more drastic action, it's hard to see any reason to dismiss this signal. That said, note that stocks tend to continue to rise for some months after the curve initially inverts Credit Suisse reckons that since 1978 US stocks have typically risen for an average of about 18 months after the initial inversion. But it's another good reason to be wary of this overvalued market.



Investment strategy

The trouble with "World" stockmarket indices and how to fix them

Indices such as the MSCI World or the FTSE World are not an accurate reflection of the global economy
17 Feb 2020
Investment strategy

Green investment: from "sensible re-pricing" to full-on mania

Change is afoot, says John Stepek. Everyone is waking up to the fact that we need to do more to protect the environment. That presents opportunities f…
13 Feb 2020
Investment strategy

The secret to avoiding being panicked out of your portfolio

With the coronavirus continuing to occupy headlines, investors still aren’t sure how to react. But the one thing you mustn’t do is panic. Tim Price ex…
11 Feb 2020
Investment strategy

Just five assets matter for investors. Here's what they are

Every investor’s needs are different – but most can be met by the right combination of five investments
11 Feb 2020

Most Popular

House prices

The biggest risk facing the UK housing market right now

For house prices to stagnate or even fall would be healthy for the property market, says John Stepek. But there is a distinct danger that isn't going …
17 Feb 2020
UK Economy

How the BBC can survive the end of the TV licence

The TV licence that funds the BBC is looking way past its sell-by date, says Matthew Lynn. Here's how it could survive without it
16 Feb 2020

Money Minute Monday 17 February: good news ahead for the UK economy?

Today's Money Minute looks to a week in which we get the latest employment and inflation numbers, plus retail figures for January and a slew of eurozo…
17 Feb 2020

Why investors shouldn’t overlook Europe

SPONSORED CONTENT - Ollie Beckett, manager of the TR European Growth Trust, tackles investor questions around Europe’s economic outlook and the conseq…
6 Nov 2019