Should investors be scared of the big bad yield curve?

Typically, in the context of history, a recession has occurred within the following 18 months on average, when the yield curve inverts.

Bond markets have sent another recession warning signal, with a more noteworthy part of the bond yield curve inverting for the first time since the global financial crisis.

Earlier this year, in mid-March part of the yield curve inverted, the bit between the 10-year and three-month Treasury bonds (debt issued by the US government).

The part of the bond market that is viewed as much more worrying if it inverts, though, is the difference between 10-year and two-year Treasury bonds. Yesterday (14 August), this section of the yield curve inverted, amid fears US economic growth is cooling, which is not being helped by trade war tensions escalating with China.

An inverted yield curve occurs when longer-term bonds have a lower yield than short-term ones of similar quality. It implies investors are worried about the short-term economic outlook, as they are willing to accept less interest on a 10-year bond than a two-year bond. This is why an inversion spooks equity markets, which sold off notably yesterday, with the S&P 500 falling by 2.9%, which is a big one-day fall. 

Ed Smith, head of asset allocation research at Rathbones, noted in March:

"A negative reading is referred to as an inversion, and it is highly unusual. The worrying thing is that it signals the US economy may be overheating in the short run."

Typically, in the context of history, a recession has occurred within the following 18 months on average. Richard Carter, head of fixed interest research at Quilter Cheviot, agrees investors have become increasingly worried about the global economic outlook, with Europe's biggest economy Germany on the brink of recession. Moreover, the UK economy is also dangerously close to entering recession.

He adds that worse than expected data out of China, including the weakest industrial production numbers in 17 years, also paints a gloomy prognosis for the global economy. "One closely watched measure is the shape of the US yield curve and yesterday (14 August) the 10-year bond yield dropped below the two-year yield, indicating that investors expect the Federal Reserve to cut interest rates quite substantially in the coming months.

"This inversion of the yield curve is often seen as a precursor of recession, although the distortions produced by quantitative easing might have reduced its reliability this time around. The yield curve in the UK has also just inverted due largely to the increased risk of a no-deal Brexit at the end of October."

Predicting recessions and turning points in markets is extremely difficult, adds Carter, but he notes "the risks have certainly increased". He adds:

"We continue to see good long-term value in equity markets, but would clearly welcome a reduction in US/China trade tensions as well as a sensible resolution of the Brexit conundrum." 

Jargon buster: yield curve

The yield curve describes how bond yields typically 'curve' up with increasing contract length. This is because lenders generally demand a higher yield to compensate for the additional risk of parting with their cash for a longer period of time. Future inflation expectations are a big driver behind the shape of the yield curve; if inflation is expected to be higher in the years to come, yields will in theory rise across the curve.

In market parlance, the term yield curve is generally used as shorthand for the difference between the yields on the 10-year and two-year Treasury bonds (debt issued by the US government).

Carter says:

"Sometimes, it's measured by the difference between the 10-year and one-year Treasuries - we favour this over the 10- to two-year curve because it's ever so slightly more stable."

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