Stock markets around the world have tumbled this week in response to a warning signal from the bond market. The signal in question is known as “yield curve inversion.” It describes the relatively unusual situation where long-term interest rates are lower than short-term interest rates.
This week, for the first time since 2008, 10-year US treasury bonds are yielding less than 2-year US treasury bonds.
Known as “yield curve inversion”, this phenomenon has alarmed investors. The backdrop of ongoing trade tensions between the US and China and an escalating crisis in Hong Kong has not helped.
What is “yield curve inversion” ?
Intuitively, it should cost more to borrow for a longer period of time than a shorter one. When this normal state of affairs is reversed, it suggests investors may be expecting lower levels of growth and lower interest rates far into the future. Historically, yield curve inversion has proven to be a pretty good harbinger of a weak economic environment and even recession.
Is this important? Yes – but there are a number of caveats to bear in mind.
- Firstly, recession does not immediately follow inversion. Our data indicates that there is typically a lag of 12 to 20 months before a recession. In the past, equity markets have continued to do well for a period of time after the yield curve first inverts.
- Secondly – irrespective of the yield curve – recessions normally occur when real (after inflation) interest rates are above 2%. Today, they are around zero and have fallen in recent weeks.
- Finally, the previous seven yield curve inversions have occurred when short-term rates have been rising in response to strong growth and inflation. Today’s situation is very different – inversion is being driven by falling long-term rates. There is little precedent for what happens in this scenario.
We have been positioning portfolios for a weaker economic environment for some time. We have benefited from our exposure to government bonds and gold, both of which have performed strongly as economic concerns build. We have a neutral exposure to equities and have been taking profits in higher-risk areas of the equity market.
We are not making significant changes to portfolios for now, though we constantly re-assess our positioning in light of the evolving economic outlook.