The yield curve has inverted. Is a recession coming soon?

TL;DR

• The yield curve shows how much holders of a government bond are getting paid for holding the bond for different lengths of time.
• When the yield is lower in the longer term (eg 10 years) compared to the short term (eg 2 years), the yield curve is said to be inverted.
• All the US recessions in the past 40 years have had warning signs from an inverted yield curve. However, not all yield curve inversions led to a recession.
• US equity markets have continued to go up after a period of about 12 months after the yield curve inverts in the past.
• Beansprout will stay invested for now. However, we are wary of recessionary risks and will only invest in companies with strong fundamentals.

What happened?

Cathie Woods is tweeting about it. All the news headlines are screaming how the yield curve has inverted and how it is a warning sign for a potential recession.

For investors that may not understand the bond market well, we hope to share with you why everyone is focused on this financial term called the yield curve.

Governments around the world regularly borrow money through the issuance of bonds. The proceeds of these bonds are used for various purposes including spending on infrastructure.

Holders of the government bond receive a payment for lending the government money over a fixed period of time.

This is called the bond yield, or the return an investor is able to get from collecting the interest payments tied to the borrowing.

The borrowing could also be for different lengths of time. For example, some borrowing are relatively short term (eg 3 months). Some are relatively long term (eg 10 years).

Putting this together would give rise to the yield curve, a graph that shows the difference between longer-tenure and shorter-tenure government bond yields.

Most of the time, yields on shorter-tenure bonds are lower than longer-tenure bonds. Hence, yield curves are upward sloping usually.

The logic for this is simple. Investors expect to be compensated for committing their money for longer periods of time.

In the chart below, the yield on the 30-year government bond at 6%, and the yield on the 3-month treasury bill is at less than 1%.

The yield curve is upward sloping as the holder of the 30-year government bond expects to receive a higher return than a holder of the 3-month treasury bill.

Source: Investopedia

What is an inverted yield curve?

However, there are times when the yield curve inverts and starts to slope downward.

This phenomenon is known as a yield curve inversion.

Prior to an inversion, the yield curve would start to flatten. The gradient of the curve will become gentler.

This could be caused by either: (1) a rise in short term yields (2) a dip in long term yields.

Once yields on shorter-tenure bonds exceed longer-tenure bonds, an inversion occurs.

When inversions happen, it means that investors would be paid more to lend to the government on a shorter-tenure than lending to them on a longer-tenure.

Source: XPLAIND

As shown in the chart below, the yield curve inverted on 1^st April for a short duration and recovered back to positive sloping territory on 5^th April.

Source: U.S. Federal Reserve

Why should I bother about the yield curve inverting?

Historically, an inverted yield curve has signaled several recessions.

This could be a reflection of market participants expecting the Fed to cut its policy rates in the future to help to boost growth.

From a bank’s perspective, an inverted yield curve could hurt its profitability. This is because they would typically borrow short term at low rates and lend out in the long term at higher rates.

With an inverted yield curve, they might be less willing to lend, thus hurting economic growth.

Since the 1960s, all the US recessions have had early indicators in the form of a yield curve inversion.

According to Bloomberg, it takes an average of 14 months for a recession to happen in the U.S. after the first inversion.

However, not all yield curve inversions subsequently led to a recession. For example,  the 2-year vs 10-year US government bond yields inverted during the Russian debt crisis in 1998.

But the US managed to avoid a recession during that period.

Source: U.S. Federal Reserve

What would Beansprout do?

Based on past episodes of yield curve inversion, US equities continue to rise after a yield curve inversion.

After the first inversion, it typically takes about 12 months before we see a peak in the S&P 500 index.

The average return during this period is at 18%. It can even be an upside of 34% from the time of yield curve inversion to the peak, like what we saw in 1988.

This could be because economic activity and company earnings might remain strong before the onset of a recession.

As we have seen, the US economy remains healthy today with low unemployment numbers.

Hence, we would continue to stay invested, while watching out for recessionary risks.

Our portfolio would also be in stocks that we believe are supported by strong fundamentals, and can continue to do well in the event of an economic slowdown.

We would also continue to track the yield curve through the link here.

Find our why we prefer value stocks over growth stocks with the inflation risks this year