Does it matter when bond returns turn upside down?

The US yield curve has ‘inverted’ ahead of every US recession for decades.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

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!

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

More on Investing Articles

Investing Articles

Could the JD Sports Fashion share price double in the next five years?

The JD Sports Fashion share price has nearly halved in the past five years. Our writer thinks a proven business…

Read more »

Bus waiting in front of the London Stock Exchange on a sunny day.
Investing Articles

If interest rate cuts are coming, I think these UK growth stocks could soar!

Falling interest could be great news for UK growth stocks, especially those that have been under the cosh recently. Paul…

Read more »

Investing Articles

Are these the best stocks to buy on the FTSE right now?

With the UK stock market on the way to hitting new highs, this Fool is considering which are the best…

Read more »

Petrochemical engineer working at night with digital tablet inside oil and gas refinery plant
Investing Articles

Can the Centrica dividend keep on growing?

Christopher Ruane considers some positive factors that might see continued growth in the Centrica dividend -- as well as some…

Read more »

Smiling family of four enjoying breakfast at sunrise while camping
Investing Articles

How I’d turn my £12,000 of savings into passive income of £1,275 a month

This Fool is considering a strategy that he believes can help him achieve a stable passive income stream with a…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

2 top FTSE 250 investment trusts trading at attractive discounts!

This pair of discounted FTSE 250 trusts appear to be on sale right now. Here's why I'd scoop up their…

Read more »

Smiling young man sitting in cafe and checking messages, with his laptop in front of him.
Investing Articles

3 things that could push the Lloyds share price to 60p and beyond

The Lloyds share price has broken through 50p. Next step 60p? And then what? Here are some thoughts on what…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

£1,000 in Rolls-Royce shares a year ago would be worth this much now

Rolls-Royce shares have posted one of the best stock market gains of the past 12 months. But what might the…

Read more »