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Yield curve inversion

You may have heard or read something in the news of market makers concern about an inverted yield curve.  So what is all this about and is it just a storm in a teacup?

It all started in 1986 when a young student named Campbell Harvey published his dissertation which showed that unusual movements in rates paid on market tradable debt securities appear to be linked to economic recessions.  His dissertation studied 4 USA recessions which indicated a linkage.  More to the point, the next three recessions seemed to prove his theory – but how and why?

The idea is simple. Tradeable debt securities are issued with a fixed rate of interest but the effective rate varies, minute by minute, according to the market price paid. Once you buy, you are locked into the effective rate until maturity or until you sell. Think of fixed interest rate, fixed term deposits with no early encashment allowed and then allow your mind to see ownership of them traded in an open market. Some of the items mature to cash soon – these are called “short dated” and some mature many years hence – these are called “long dated”. In normal market conditions, you would expect to see interest rates payable on short dated items to be lower than long dated items. This stands to reason as longer term deposits tie up your cash for longer.

But, because ownership of the securities is market tradeable, market forces determine the effective rate.  For example, if something causes an unusually high demand for long dated debt securities, the price they sell at will rise and the effective rate or yield will fall.  All fine so far, but why would the demand for long dated securities outstrip that for short dated?

The theory postulates that investors who seek protection against a near future expected recession tend to buy long dated debt securities as a haven. Another reason links in to the behaviour of banks which quite often put up their rates on fixed rate fixed term loans if long dated securities pay low rates and this, in isolation, tends to stall an economy.

The two yields most closely watched are 2 year US Treasuries and 10 year Treasuries.  These yields and the yields for maturity dates between them form a curve shape when plotted on a graph.  The curve is said to be “inverted” when the 10 year yield dips below the 2 year yield.

For the last 2 years, economists and investment analysts have been watching closely for a yield curve event to occur and, at long last, we experienced a small inversion last week.

History of yield curve inversions

Do we need to be concerned about this?  To some extent, yes.  But, the same data that suggests we may experience a recession anytime between 10 and 34 months from now is also associated with equity investment returns in the post inversion period ranging between 13% and 38%.

This time around, the yield curve inversion event triggered an immediate sell off in the FTSE100 of about 7% in the week that followed. Because, the whole idea of yield curve inversion is now more widely accepted as an important lead indicator of a recession to come, market pricing behaviour over the next 20 or so months may be markedly different to previous inversion events.

So what can we conclude from all of this?  Previous to the yield curve inversion, it was already known that a recession event of some kind must not be far away.  The inversion event last week underscores this and suggests equity markets will peak between 2 and 22 months from now and a recession may occur between 10 and 34 months from now.

You will have noticed that even though we know quite a bit about yield curve inversions, the fantail of possible outcomes is still quite large – too large, in my sincere opinion, to make any dramatic moves in the shape or construct of your investment portfolio.

Posted in Investments, Markets