The ‘yield curve’ has inverted
THE “YIELD curve”, or the gap between long-term and short-term interest rates, inverts when short-term rates are higher than long-term rates.
When that happens, it sends a distress signal about the economy. The yield curve matters because it reflects the market’s view of the economy. In the late stage of economic expansion, short-term rates tend to rise during Fed tightening cycles. As well, long-term rates can fall when there is rising demand for bonds. When long-term rates falls below shorter ones – or when the yield curve inverts – it indicates that investors are moving toward the safety of long-term government bonds.
Historically, the yield curve has been a reliable predictor of a coming recession. Each and every one of the past seven recessions since the 1960s has been preceded by an inverted yield curve. Recently, the spread between three-month bills and 10-year treasuries inverted in March – and it has triggered a panicked sell-off in the stock markets.
While it is one of the best warning signs of recession, the inverted yield curve is not necessarily a sell signal for stocks as there has historically been a significant lag from the time of yield curve inversion to the start of a recession. Our research shows that in the past seven US recessions, it took an average of 20 months to reach the next recession. This suggests that the US economy could enter recession in late 2020.
The stock market, on average, peaks eight month before a recession starts. Therefore, if the historical pattern holds, we are still 12 months away from a market peak. During a recession, the stock market usually continues to fall for several months. The market then bottoms out about six months after the start of a recession, and usually begins to retrace loss before the economy begins to recover.
To repeat: We are likely quite some time away from a recession and the accompanied stock market peak. Nonetheless, prudent investors should start thinking about their investment strategy to cope with that possibility. Those who have short- to medium-term investment goals should focus on capital preservation and start diversifying their investment portfolio into less risky asset classes such as bonds or gold. Those who have a long investment horizon can continue to invest in the stock market but should focus on defensive sectors with a long-term growth story such as the global health-care sector.
Because one thing is certain – this cycle will end at some point.
Contributed by KOMSORN PRAKOBPHOL, head of Tisco’s economic strategy unit (ESU).