Why all the fuss about an inverted yield curve?
Before we get started, a brief definition.
An inverted yield curve describes an interest rate environment where long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality.
In this case, it’s the US Treasury yield curve at stake and it’s become inverted for the first time in more than ten years.
It’s inverted because investors want a higher rate of return on their short-term government debt, due to the anticipation of rising price inflation and higher interest rates.
But at the same time, investors believe long-term inflation and economic growth will be modest. When these two factors happen at the same time, the yield curve becomes inverted.
This is important because when the yield curve inverts, it’s considered to be a strong predictor of an economic recession.When the yield curve inverts, it’s considered to be a strong predictor of an economic recession Click To Tweet
How strong of a predictor?
In each of the past seven economic recessions (defined as two successive quarterly periods of GDP decline) the spread between short and long-term Treasury yields has fallen below zero ahead of the recession starting.
US Treasury stocks are the biggest bond market in the world and analysts have been predicting an inverted yield curve for about year.
So this inverted yield curve hasn’t come completely out of the blue. It has regardless managed to spook investors, driving the main US stock market indices lower on the expectation of tougher economic times ahead.
And despite a clear link between inverted yield curve and economic recession, these things don’t tend to happen straight away.
The last time it happened, back in August 2005, it took another 28 months before the recession materialised in the US.
As well as the length of time it could take for an economic slowdown or recession to materialise, there’s another good reason for investors to hold their nerve despite this technical event.
The most important yield curve inversion, in terms of a predictor of recession, has not been seen, yet. This is the relationship between 3 month and 10 year US Treasury stock.
This yield curve is not inverted yet, which reduces the likelihood of an economic recession ahead.
It’s also worth noting that the correlation between economic recession and stock market recession is far from perfect. Just because we get one doesn’t guarantee we will see the other.
Another measure used to predict a coming recession in the next 12 months, the Cleveland Federal Reserve’s recession indicator, currently stands at 20.3%. It’s up slightly from October, when it stood at 16.6%.
They say that, despite a flatter yield curve, expectations of economic growth stayed the same. Their recession indicator incorporated a string of strong GDP growth numbers in recent quarters.
The current run of economic growth in the US started in June 2009. It’s age is why investors are so focused on how long the good economic times can last.
If economic growth in the US continues until next summer, to reach a decade old, it will be the longest in US history, comparable with the period of growth which lasted from 1991 to 2001.
There were eleven economic cycles between 1945 and 2009, lasting on average for less than six years. That makes the current run already exceptional.
But investors should not obsess over such things and instead focus on the long-term returns they can experience from a well diversified portfolio.
Some equity market volatility is inevitable, as part of the price investors pay to expect equity style returns, but this is not necessarily triggered by economic hardship.