An inverted yield curve shows that an economic slowdown may be imminent.
The yield curve is one of the leading indicators that analysts use to predict the direction of the stock markets. In the United States, analysts have used it to forecast all the recessions in the last five decades. The yield curve has not been given much attention in India.
Let’s take a closer look at what an inverted yield curve is and what it means:
What is the yield curve?
The yield curve is a line on a graph that tracks the yield of bonds that have the same credit quality against their maturities. Most reports compare the yield curve of three-month, two-year, five-year, and thirty-year US treasury debt. The yield curve serves as a benchmark for different types of debt, such as bank loan rates and mortgage loan rates.
What are the main types of yield curves?
The yield curve’s shape predicts changes in future economic activity and interest rates. The primary forms that a yield curve can take are normal, flat, and inverted.
Normal yield curve
Normally, bonds with a longer maturity have a higher yield than shorter maturity bonds because of the risks related to time.
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Shorter-term yields and longer-term yields are very close to each other in a flat or humped yield curve. A flat yield curve can predict an economic change.
Inverted yield curve
Shorter-term yields are higher than longer-term yields in an inverted yield curve. An inverted yield curve shows that a recession may be imminent.
Also read: How P/E and market cap-to-GDP ratios can help you in investing
What is the basis of the yield curve?
The basic premise of the yield curve is that longer-term bonds should offer a higher yield than shorter-term bonds. Investors usually expect lower returns when they invest for shorter periods. They expect higher gains when they invest for more extended periods. For example, a one-year bond ought to offer a lower yield than a ten-year bond.
However, at times, shorter duration bonds offer higher yields than longer duration bonds at times when investors lack confidence in the economy. They invest in shorter duration bonds because they expect the value of short-term bills to fall in the future.
What does an inverted yield curve show?
An inverted yield curve is the rarest of the three main types of yield curves. It is also called a negative yield curve and is a predictor of a recession. The yield curve inverts when long-term debt instruments have a lower yield than short-term debt instruments with the same credit quality.
Yield curve inversion has occurred before many US recessions, showing that the yield curve can predict turning points in the business cycle. Yield curve inversion had also predicted the global financial crisis of 2008, two years before it occurred.
What did the yield curve inversion of December 2018 indicate?
The yield curve inverted on December 3, 2018, and this was the first yield curve inversion since the global financial crisis of 2008. The yield curve was back to normal on December 14, 2018.
Investors and analysts are keeping a close watch on the movements of the yield curve. If it inverts once again and remains inverted, it could mean that a recession is imminent.
Is the yield curve relevant in India?
The yield curve has not been a reliable indicator of recessions in India, but once it inverts, equity markets start falling. In the last 15 years, yield curve inversion occurred on four occasions in 2008, 2011, 2013, and 2015. The markets had delivered negative returns during these periods.
There is a negative correlation between stock market indices and the gap between the ten-year bond yield and the one-year bond yield. As this gap narrows, the likelihood of a fall in the equity indices increases.
Also read: Financial Ratios Analysis for Investors
Is a recession likely to occur soon?
There is a time lag between yield curve inversion and an economic slowdown. A slowdown may not occur immediately after the yield curve inverts. Yield curve inversion occurred more than two years before the global financial crisis of 2008.
Worries about an imminent economic slowdown in the US have increased in recent months. Investors are worried about the disturbing signals emanating from the US bond market.
The US yield curve has been flattening, and some parts of it inverted in December 2018, indicating the direction in which the economy is heading.
Yield curve inversion causes negative sentiment
The yield curve is making markets nervous, and investors have been dumping stocks. Yield curve inversion is considered to be the top predictor of a recession. Yield curve inversions have occurred before the last seven recessions.
Yield curve inversion impacts investor sentiment, creating a negative feedback loop. Worries about stocks and the economy result in lower bond yields, leading to misgivings about yield curve inversion, which causes even more stock market weakness.
Markets are aware of the implications of yield curve inversion, and this can turn into a self-fulfilling prophecy. A recession could occur because people believe that it is likely to happen.
People start behaving like a recession is beginning and turn their worries and fears into reality. While you shouldn’t ignore the flattening of the yield curve, this isn’t the only indicator to consider.
Financial conditions are still relatively accommodative, and the recent tightening is limited compared to the shocks that came earlier. Economic conditions could ease if leaders can resolve risks like the US-China trade war and Brexit.
Conclusion
Yield curve inversion is one of the main predictors of a recession. The yield curve had inverted more than two years before the global financial crisis of 2008. A flattening yield curve impacts investor sentiment and this can create a self-fulfilling prophecy. However, the yield curve isn’t the only indicator to consider.
