Yield curve fear is back

One of the most reliable recession indicators in markets is starting to flash red. Investors should beware

Between war and inflation, markets have a lot to worry about. So fretting over an arcane-sounding bond market phenomenon may not be top of your priority list. But if history is any judge, it should be. We’re talking about the “inverted yield curve”. We explain exactly what a yield curve is here, but, put simply, when a yield curve inverts, it means that the interest rate on long-term government bonds is lower than that on short-term ones. That’s a sign that the market thinks interest rates will have to fall in the future, which implies slower growth, or even a recession. 

The good news is that the most significant bit of the yield curve, the gap between the two-year US Treasury bond and the ten-year, is yet to invert. As of Monday, the ten-year yields around 2.3% while the two-year yields 2.1%. The bad news is that bond investors are betting that within three months, the two-year yield will be above the ten. And in the last 40 years, every time that’s happened, a recession has followed within 24 months. 

It’s probably not different this time

No indicator is perfect and we only have a limited data set to draw on (recessions don’t happen that often). So it could be different this time. For example, Morgan Stanley strategists believe the curve will indeed invert, but that this time it won’t signal a recession, because of distortions related to quantitative easing. However, as Eoin Treacy notes on FullerTreacyMoney, “rationalisations for why this time is different crop up whenever the yield curve approaches inversion”. But what could prevent the inversion? 

Inversion is typically driven by markets fearing that Fed will raise interest rates too aggressively for the economy to handle. That’s exactly what’s happening now. So if anything prevents the inversion, it’s likely to be the Fed either getting cold feet, or clear evidence that the economy is genuinely running hot enough to handle rate hikes.

Perhaps a more important question for investors is: if we do face a recession, is there anything you should do?

Recessions are undeniably bad news for stockmarkets. Robert Armstrong, writing in the Financial Times, cites Bank of America’s Stephen Suttmeier, who reckons that “during the average recession, the S&P 500 drops by a third over 13 months”. Yet history also suggests that markets typically don’t hit a top until the inversion has happened, which implies the US market could still have a way to rise before it goes down. So despite the indicator’s strong track record, trying to use it to time the market is futile. A better bet is to make sure you have cash to take advantage of any opportunities that arise; and focus on buying at low valuations, rather than predicting the future. 

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