The Motley Fool

Does it matter when bond returns turn upside down?

Do you know where you were for The Great Yield Curve Inversion of 2019?
 
Note it down! Your grandkids will surely want to hear!
 
What’s that? You don’t have the foggiest?
 
You’re not even – come on, speak up – exactly sure what a yield curve is?
 
Well count yourself luckier than the world’s professional traders. They saw tens of billions of dollars wiped off their share portfolios on Friday 22nd March  – and their weekends ruined – when an ‘inversion’ warning flashed and their peers began to dump shares faster than you can shout “fire!”
 
But I don’t blame you if it passed you by.

Global stock markets have not stayed down since that supposedly fateful March day.
 
Mostly markets have meandered – as if someone shouted “fire” but then people wondered if they really ought to panic, or if the stock market rally was still on.
 
“I’m sure I heard ‘fire’ but maybe I heard ‘higher’?”

What’s going on?

Born in the USA

Before I explain the jargon, I should stress we’re talking about the US yield curve here, based on the yields available on US government bonds.
 
There’s a British yield curve, but it’s not massively relevant today.

The US is the globe’s dominant economy and the US dollar is the reserve currency of the world. At the risk of making our rarely excessively modest North American cousins feel even more special, the truth is what happens in the US has super-sized importance.
 
And then there’s Brexit.
 
To my mind the uncertainty and hedging resulting from everyone trying to navigate Brexit means any signals such as the UK yield curve are even less useful than usual.
 
Besides, it was the US yield curve that inverted last month and sent shares crashing, so that’s the one that matters right now.

Curves in all the right places

So what is the yield curve, and why is it anybody’s business if it inverts?
 
Warning: Here comes the science bit!
 
You probably know most government bonds pay their holders an income according to a set schedule, before eventually returning their capital value on maturity.

  • A 10-year bond, for instance, will pay a coupon (interest, basically) for a decade before repaying the holder the full face value of the bond when it matures.
  • A five-year bond does the same but only has five years to run before maturity.
  • And so on for bonds of all maturities.

Knowing the coupons due and the capital that will be repaid at maturity, you can work out the return you expect on an annualized basis for any bond – its ‘yield’.
 
This is quite a tricky calculation, but luckily we never need to do it because these yields are widely published by outfits such as Bloomberg.
 
And such companies also publish the yield curve.
 
The yield curve is a graph showing the yield available on government bonds of all different maturities in the form of a curve.
 
By looking at the yield curve, you can compare the return available on bonds of any maturity – as well as seeing the curve’s overall shape.
 
This last bit is important!

Time is money. Usually.

Theory tells us to expect a 10-year bond to yield more than a shorter-term bond.

This is because you want to be paid more for investing money for 10 years compared to three months, for example.
 
If the return over three months and 10 years was the same, why not just invest for a shorter time and retain flexibility?
 
It’s the same principle you and I use when we’re comparing fixed rate savings accounts. We expect a higher return for locking our money away.
 
However occasionally this relationship breaks down.
 
And that is what happened in March, when the US yield curve inverted.

Be prepared for a choppy ride …

This so-called inversion occurred because for a short while, the yield on 10-year US government bonds dipped below that offered by three-month bonds.

This means the market was offering lower returns to committed investors who locked their money away, compared to those after a short-term fling with a three-month bond!
 
This doesn’t make much sense on the face of it – unless you’re a bond investor who thinks 10-year yields are going to fall further, and so it’s better to buy now.
 
But why would someone think the 10-year yield would fall further?
 
Probably because they fear a recession!
 
In recessions, growth goes into reverse, investors get scared, and central banks cut interest rates. This is good for bonds (which means lower yields) but bad for shares.
 
At last we can see why last month’s yield curve inversion scared the stock market.
 
The inversion suggests the market may have sniffed out an imminent US recession.
 
The last time the US yield curve inverted was in 2007. You may recall what happened next – the biggest recession since World War 2 and an almighty stock market crash.
 
This isn’t a one-off, either. The yield curve has inverted before all US recessions over the past 40 years.
 
The US stock market has typically peaked shortly afterwards, too.

…but think twice before taking evasive action  

US recessions are not good for investors. Not only does the US market make up more than half the global stock market by value – its economy affects companies everywhere.
 
However having explained what the yield curve inversion is and why you should care, I’ll conclude with a few caveats.
 
This is investing – nothing is black and white.
 
The most important caveat is that while all US recessions have been preceded by a yield curve inversion, the opposite isn’t true. Sometimes the curve inverts and no recession follows. It’s not an infallible indicator.
 
Also recessions aren’t the end of the world. They are a natural feature of capitalism. The last two US recessions were very painful so we’re used to thinking they must be terrible affairs, but a short, shallow recession doesn’t do too much long-term damage.
 
Then we should note the US yield curve only briefly inverted. As I write it’s – well – un-inverted. The academic who popularized the signal says you need a sustained period of inversion to predict anything.
 
Finally, I’d warn against trying to time markets based on indicators like the yield curve.
 
The average person is likely to be well behind the curve – excuse the pun – and by the time you make your move, professionals may have already priced in the impact of a recession. You could be selling your shares at the worst time.
 
What’s more, if you sell shares because of some particular indicator, you’re also going to need an indicator to tell you when to buy back in again. Good luck with that!
 
Finally, good companies can do okay in recessions. Their share prices might fall, but their competitors may be going bust. Great companies can emerge from a recession in a stronger position than when they entered.
 
As ever, invest sensibly and for the long-term. If you feel you’ve gone a bit crazy and put too much in shares – or invested in faddy companies that you don’t believe in – then by all means take the yield curve inversion as a nudge to put things right.
 
But otherwise, I’d leave the cycle of panic and pile-on for the professionals to get wrong!

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