Yield curve danger signal spooks investors

The yield curve inverting sounds dry and dull, but has been the talk of the financial markets in the past week. Sceptics fear it heralds an imminent economic recession, and the phenomenon prompted a global slump in equity markets last Friday.

But what significance does the yield curve have, and should an inversion be cause for concern? Danske Bank’s investment strategist, Lars Skovgaard Andersen, gives us the answers.

To invert means to turn something upside down or to put in the opposite position or order, and an inversion of the yield curve essentially means that long yields are lower than short yields – while normally it is the other way round. The yield on long bonds is usually higher to compensate investors for the longer wait before they get their money back, plus there is more uncertainty about how much inflation might erode the value of their future payments.

This is because an inversion of the yield curve has historically been one of the best predictors of an imminent downturn in the economy. At the end of last week, the US 3-month and 10-year yields inverted, and if this inversion remains in place for 10 days in a row, historically the economy has, on average, slipped into recession 311 days later.

Nevertheless, that does not necessarily mean a recession will occur this time. The inversion is a historical statistic, yet it creates concern among investors. Moreover, some economists believe the central banks’ massive bond buyback programmes have had so great an effect on the bond markets that the yield curve inverting no longer functions as a signal; though we cannot be sure about this until a recession materialises – or doesn’t.

No, that is definitely not our view. Since 1950, it has taken 19 months, on average, from the inversion signal until the US S&P500 equity index has peaked, which in turn has meant an average return of more than 21% during this period. But again, these historical patterns are of course no guarantee that we will continue to see rising equity prices going forward. Nevertheless, here at Danske Bank our expectation is that we will continue to see reasonable returns from equities in the coming year, and that equities will generate a more attractive return than bonds. That is also why we are maintaining our overweight in equities.

We have to get a little technical, but yields invert, for example, when investors expect inflation to fall in the future and the market prices in the US central bank eventually having to lower interest rates again to stimulate the economy. The expected future reduction in interest rates could be first priced into long yields, which then become lower than short yields. Generally speaking, we can say that an inversion of the yield curve reflects an expectation that the economy will slow.

Looking at the data from the past three periods with inverted yield curves, all sectors were in positive territory after three months. However, there were also a few interesting observations: Those sectors that were performing best going into these periods were still among the winners later on, while at the same time there was a rotation from cyclical equities into more defensive sectors. In other words, investors reduced risk by rotating into more defensive sectors in general while at the same time holding onto the sectors that had given them the most positive return prior to the inversion. So if history repeats itself, we should hold onto IT equities and rotate into defensive sectors.