Should an inverted yield curve worry investors?

By: Tim Bennett

A big bond market indicator has been flashing red recently. Tim Bennett asks how worried investors should be in his latest video.

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Should an inverted yield curve worry investors?

“Flattening US yield curve stirs US recession fears” said a recent FT headline. So, here I take a look at what that statement means and consider the implications for investors.

An image that is causing the jitters

This chart shows what has happened to the difference in yield for US Treasuries with short-term maturities of two and five years as at the start of December 2018. It slopes from left to right in a downwards direction, meaning that the gap between the two has diminished, then more or less vanished. Recently it has even dipped into negative territory. This is what some investors are worried about. Before we look at why, a bit of quick revision.

Yield curve basics

Yield curves plot yields for similar groups of bonds – here US government IOUs, called Treasuries – with different maturities. The yield is, in turn, the total annual return you would expect for holding a particular bond. Because the income on most of these IOUs is fixed, when the price moves up it squashes the yield and vice versa. Normally, you would expect to be rewarded with a bigger yield for taking time risk. Put another way, all other things being equal, a five-year bond should be a bit cheaper than a 3 year (and offer a higher yield) because an investor is taking time risk by investing in it, especially if interest rates are expected to rise. That’s because the income they will receive will not change, as it is fixed. The fact that five-year yields are above three year, and three year above one year, creates an “upward sloping” curve. What we have seen recently suggests the opposite, with signs that the gap between the two may even turn negative.

The bear case

Pessimists point to the fact that the gap between yields on longer-dated and shorter-dated bonds has narrowed as evidence of a possible future recession. After all seven of the last big ones have been preceded by this type of change. Why? Because if growth is expected to slow, interest rates are generally cut, not raised. And if that happens, the “term premium” for longer dated debt disappears as investors start to lock in the future fixed income available from government bonds by buying them and pushing down yields as they do so.

The economic anomaly

Optimists may counter this argument by saying that recent economic data for the US economy has been relatively strong.
They also point to “technical” short-term factors that may explain why the “short-end” of the yield curve has moved into inversion.

The timing headache

However, the bears point out that although some of these short-term factors may carry some weight, an inverted yield curve usually presages trouble further out. They cite August 2005 as a prime example, ahead of the credit crisis.

The key indicato

So, what to make of this debate? Much hangs on what happens to the rest of the yield curve that represents yields on longer-dated bonds. At the time of writing this was “flat” but should it invert too, the bear case is strengthened based on past data.
Bulls will rely for now on technical reasons for the difference between the black line above (the near-inversion at the short-end of the curve) and the black one (a flat scenario where the gap between spreads has remained low but fairly constant). They will also point to the fact that different parts of the yield curve historically have presented different signals and that recent inversions in just one part have not lead to immediate, or even delayed, recessions.
For investors the message is – watch this space. The problem with yield curves is knowing which space to watch.
To get more from our bond experts on the yield curve, please speak to an Investment Manager.