In-depth Analysis

What does an inverted yield curve imply for the financial markets?

What does an inverted yield curve mean?

First of all, the yield curve is displayed by a line on a graph that is created by plotting the interest rates of bonds, or their ‘yield.’ These are bonds that have the same credit quality but not the same period of time to maturity. The direction of the line, or its slope, can give clues as to what might be coming with interest rates in the future, and even the strength or weakness of the economy.

Most often the comparison is made between three-month, two-year, five-year, ten-year, and thirty-year Government bonds, which are generally updated on a daily basis on trading days.

There are three types of shapes created by the yield curve. A curve that slopes upward is called a “normal” curve and generally indicates economic expansion, a curve that slopes downward is “inverted” and can indicate economic weakness. A straight line is simply referred to as “flat” and is usually seen in the transition from inverted to normal – or vice versa.

When conditions are economically ‘normal’ in terms of the global or local economy, bonds that have longer maturities will generally be considered slightly more risky and as a result carry a higher yield than those of bonds with a shorter period to maturity, which might be thought of as less risky. 

If the economic climate becomes more uncertain and market sentiment sours however, investors may feel that making a switch to buying longer-term bonds is safer than the alternative shorter-term bonds, as they look to preserve their capital and plan for when interest rates decline and value appreciates down the track. This demand for longer-term bonds drives the price up and consequently causes their yields to drop.

It’s a somewhat rare occurrence, but once an inverted yield curve is identified, it’s usually viewed as a fairly accurate forecast of an economic recession in the near future (based on what happened in the past when inverted yield curves were observed). 

There’s no way to know exactly when, but most of the times it’s been observed in recent history suggest it can happen within six months to two years.

What does it imply for the financial markets?

With the background of inverted yield curves in mind, you can potentially adjust your trading plan to be more suitably prepared for an upcoming downturn and either reduce your losses or invest in stocks (or assets) that have the opportunity to do well in these conditions before it happens.

Some of the steps you might think of taking in the lead-up to a recession include the following:

  • Invest in more defensive types of stocks. These might be companies that sell products that will still be in demand regardless of the economy. Consumer staples like household products, personal care products and groceries are usually a safe choice, as well as the healthcare sector.
  • Go wider with your portfolio to international markets for more diversity. Not all economies across the globe are closely correlated, so you may be able to still enjoy strong returns in an emerging economy and avoid the downturn closer to home. Just be sure to do your research and avoid the risk of volatility and low liquidity that can be common in certain places.
  • Think about investing in Gold. It’s typically considered a reliable hedge during a recession and a safe haven for preserving capital during volatility because it is precious, limited, and fairly liquid. Buy ETFs, derivatives like CFD, the raw metal itself, or even invest in a mining company.
  • Look into real estate investment options as they can be a strong investment during a downturn. You can purchase a property for its capital gains opportunity, rent out a home for tenants, or invest in ETs specific to real estate, REIT, or REIG, that allow you to put up a small amount of capital but still get exposure to the market.
  • Be wary of investing in companies that are cyclical and produce and/or sell products that are non-essential or emerging. Think technology companies, gaming, or even things like high fashion for example. These types of industries can be hit really hard in a downturn, because the consumers that they rely on for business are presumably struggling to buy the essential everyday items that they need already. Keep in mind that when conditions improve though, these types of companies might rebound well if they make it through. Think about buying these stocks on the cheap during the dip.

Final word

An inverted yield curve should be taken as just one tool amongst many forms of analysis as predictors of future movements of the economy. After all, they don’t determine the timeframe of the shift and for how long it will last.

How much weight you give to the information you gather will depend on what type of investor you are and if you tend to be swayed by the highs and lows of market sentiment, or ignore the noise and invest for the long term. 

The market will recover as it always does, and there will be opportunities on the way back to recovery and strong economic conditions.

Possibly the best thing to do is to stay positive and keep referring back to your long-term investment plan, which should include a well-reasoned risk management strategy, and diversify your portfolio as required to manage your exposure to the risk of a recession, and as usual, never invest more than you’re comfortable losing.

 

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