Is an Inverted Yield Curve Predicting a Recession?

 
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By Miles Clyne

The normal yield curve is a yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. This gives the yield curve an upward slope. This is the most often seen yield curve shape, and it's sometimes referred to as the "positive yield curve."

 

Normal Yield Curve

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Why does an inverted yield curve happen? First let’s review a little history. When a government wants to slow economic growth to prevent inflation, short-term interest rates can be raised.  When a government wants to stimulate an economy, interest rates can be lowered. The result of the weak economy is low long-term interest rates. What would drive longer term rates down below short-term rates are investors becoming more pessimistic about the short-term prospects of the economy, so they move to longer dated bonds, thus lowering their yield as demand raises the price of the bonds. In this environment, the demand for short-term bonds is low; therefore, governments and institutions have to increase the interest rates they pay to attract investors to short-term bonds.  Hence, an inverted yield curve could indicate that a recession may be on the horizon.

 

Inverted Yield Curve

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The yield curve has proven to be a reasonable indicator of future recessions. Some economists are getting nervous as signals are flashing yellow—not quite red, but certainly not green. However, the yield curve is only an indication of a potential recession not an absolute definitive signal.

The yield curve suggests the Canadian economy may be in for an economic slowdown within the next two years. A risk is that enough people believe it and they start moving money out of the market, it can become a self-fulfilling prophecy. Yield curve inversions have been associated with nearly every recession since 1962. But there is a major difference between finding a reliable indicator for economic growth and applying it to the management of a stock portfolio. The problem lies in that an inversion has historically been a reasonably reliable warning sign of an economic recession, but as investors we invest in stocks not economies and often there is a disconnect in what happens to the prices of stocks and the economy.

"The Philosophy of Technical Analysis", which is based on the premise that market prices discount (or anticipate) fundamental and economic information, is significant on its own. How technical blends with fundamental analysis is more important than knowing how the charts actually work. Because if you don't understand why charts work, there's no point in looking at them.

We trust the charts to the degree that we trust the logic behind them. They may not always tell us what is going to happen, but on average they have done a better than average job for us than doing nothing and staying fully invested through times like this.  What the Inverted Yield Curve is telling us is exactly what our own technical analysis is telling us. We have to be cautious, and we are being.  Please check out a recent article that explains in greater detail what steps we are taking in this regard.

Also note that this is by no means a definitive explanation. The more detailed information would include the durations of the bonds that give more absolute analysis of predictability. None of these have been reported in this material. The durations of the bonds are often not reported by many. So be careful when making decisions that you have all the information.