If you're worried about the specter of the yield curve inverting you may have good reason
The last nine yield curve inversions in the US have been followed by an economic recession within on average 14 months
Economic recessions are usually reflected in falling stock prices
This data sample makes it look like the yield curve is a certain predictor of a coming recession and falling stock market prices
As usual there is a lot more to the story
Bond yield is a term that describes the income that a bond pays relative to its price
The yield curve is a plot of yields for bonds of various maturities on the left side of the chart
We have shorter maturities and on the right side. We have longer maturities on the y-axis
We have yields. The term premium is a well-documented risk factor that explains the differences in bond returns
Longer maturity bonds are riskier and therefore they command higher expected returns
When you own a longer maturity bond say 10 years you own a future stream of income. That will not change for 10 years
If interest rates rise a 10 year bond with higher future cash flows can now be purchased
This reduces the relative value of your bond
Causing the price to fall such that your yield matches the yield for a new bond with similar characteristics
The falling price will be more severe for a 10 year bond than it will for a two year bond
Because the ten-year bond locks in a longer stream of cash flows
If you are locking your money up for a longer period of time you are taking more risk
Due to the higher risk associated with longer maturity bonds, they typically command higher yields
Bringing this back to the yield curve
We would expect the plot to show that shorter maturities have lower yields and longer maturities have higher yields
This is what we would call a normal yield curve
The shorter end of the yield curve is determined by the rate that a government sets for overnight lending between banks in
The US this is referred to as the federal funds rate. Well in Canada, it is referred to as the policy interest rate
The longer end of the yield curve on the other hand is influenced by the market
If the policy rate starts rising while longer maturity bonds are also rising in price driving their yields down
We will see the yield curve begin to flatten and eventually it will invert
This is currently very close to happening in the US market, which is making investors nervous
Normal yield curve is often seen as a sign of a healthy economy
An inverted yield curve on the other hand is typically viewed as a signal of a coming economic recession
This does not mean that the yield curve is a useful market timing tool. Let's look at the 2008 financial crisis as an example
US yield curve inverted in February
2006 which was followed by the S&P 500 posting of 14.5 2% return in US dollars over the following 12 months
the yield curve became upward sloping again in June 2007
Which was well in advance of the markets major downturn from October 2007 through February 2009
If you had tried to time the market on the initial inversion being out of stocks during the inverted period resulted in substantial missed gains
if you then bought back in when the slope of the yield curve became positive you would have been buying in or right before the
Crash it is still true that yield curve inversions have preceded recessions and market downturns in the u.s
Even if we couldn't have used that information to make investment decisions
but
It is far too easy to look at only US data and conclude that the yield curve is a perfect predictor of a coming recession
Let's extend the data set if we look at Australia, Germany
Japan, the UK and the US going back to 1985 there have been 14 instances of inverted yield curves in
Ten of those 14 cases, the inverted yield curve was followed by positive three-year returns in the local stock market. The U.S
May be nine for nine yield curve inversions predicting bad stock markets
But the experience in other developed countries does not support the idea that an inverted yield curve should be relied on as a consistent indicator
Should you be worried about an impending market downturn no more today than yesterday
uncertainty is a
Constant the shape of the yield curve does not change that if you like hearing about the yield curve and what it means for you
We also discussed it on a bonus episode of the rational reminder podcast
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