Bears love indicators to justify their gloomy outlook. The aptly named ‘Death Cross’ is one of the favourites of technical analysts, while an inversion of the yield curve is a favourite of fundamental analysts and economists.
Bears love indicators to justify their gloomy outlook. The aptly named ‘Death Cross’ is one of the favourites of technical analysts, while an inversion of the yield curve is a favourite of fundamental analysts and economists.
Bears love indicators to justify their gloomy outlook. The aptly named ‘Death Cross’ is one of the favourites of technical analysts, while an inversion of the yield curve is a favourite of fundamental analysts and economists.
The yield curve is simply the yields for different maturities, generally referenced to US Treasuries as the risk-free rate that sets the benchmark for global bonds. When plotted as a chart, it shows the relationship of yields at time intervals. Under normal conditions, this graph is an upward sloping curve. This makes perfect sense: investors who buy a 10 year maturity bond would expect a higher yield compared to a 2 year bond, as they are taking more risk.
As one might imagine, it is unusual for the 10 year maturity to instead yield less than the 2 year. This situation occurs when markets start pricing in future interest rate cuts. Since this is a normal response from central banks during economic recessions, thus causing forecasters to equate yield curve inversions with bear markets.
The most common form of yield curve inversion is the 10 vs 2 year comparison. Recently the yield curve inverted for the first time since 2008, and the recession forecasts came out in droves, predicting a recession in late 2019 or in 2020. These predictions are backed by how accurate a forecasting tool inversions are. Interestingly, the 10-2 year curve is still in its normal shape, with yields of 2.54 vs. 2.40. The inversion occurred in the 1 month – 3 year part of the curve, where 1m yields are 2.65% (hence higher than 10 years), and 3 year is all the way down to 2.37%.
From all these numbers if you conclude that this all looks like much ado about nothing, since we’re talking about yield differences of 0.3% at the most, you would be right.
Here are the facts. A 0.3% inversion is meaningless and does not foretell of a recession in the near future. Studying past occurrences shows that we need a bigger inversion of more than 1%, and it needs to be sustained for a long period. And even if we have both of these, the high accuracy of the ‘predictive ability’ of inversions is with a timeframe of 1-4 years. Considering that on average a recession occurs on average every 5-10 years, as market timing tools go this one is hardly useful.
The real nail in the coffin for this forecasting tool comes out by digging a little deeper. Since 1960, every recession was preceded by an inversion, but not ever inversion led to a recession.
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A closer look on the when yield curve inversions occurred, compared to bear markets, shows that out of the seven inversions that preceded a recession, in four cases the bear market started before the inversion. The longest period was a bear market that started a full eight months before the inversion. Taking into account all such events, the time range of a bear market vs. the point of inversion was from 8 months before to 21 months after. As a market timing tool, this is worse than Sell in May and Go Away, which we dissected in a previous column.
In relating all this to our current situation, we already experienced a bear market in 4Q 2018. We will need time to see whether an economic recession follows the current inversion. Considering that we have already experienced a bear market, this likely will be the 5th instance out of 10 where the bear precedes the inversion. A timing tool with 50% success rate is no different from flipping a coin, further cementing the uselessness of this ‘indicator’ which gets so much press.
News loves negative stories. When investor sentiment is as bearish as it is now (global trade war, Brexit, and now adding yield curve inversion), it is useful to remember that financial markets will usually act in the way that will confound the majority of investors.
By LEONARDO DRAGO
Co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund management services to endowments and family offices, and wealth-advisory services to accredited individual investors.
