A global macro indicator that’s been talked about a lot lately is the risk of an inverted yield curve. An inverted yield curve is an asymmetry when the short-term interest rate is higher than the long term interest rate. In normal conditions, the yield on long term bonds should be higher as a premium for the longer maturity. For example, we expect to pay a higher interest rate for a 30-year mortgage than a 15-year mortgage. The same is true for government bonds. In normal conditions, investors should expect to earn a higher yield and return from longer maturities and borrowers should expect to pay more for longer-term loans.
The normal term structure is the 3-month interest rate is much lower than the long-term 30-year interest rate. We plot the term structure on a graph for a visual representation of the trend. A yield curve can be observed in different trends and slopes. For example, an inverted yield curve is a descending slope that is asymmetric as the yield on longer-term maturities declines at a progressively slower rate of change. Inverted yield curves are rare and abnormal, so it signals something is changing. An inverted yield curve may signal a decline in economic activity, inflation, or a recession.
Below is what an inverted yield curve looks like as it inverted December 2006. The horizontal line on the left chart is the yield curve showing the shorter term bond yield on the left was higher than the long bond rate on the right. The chart on the right is the S&P 500 with a red line marking the date of the yield curve inversion. A year later, the stock market started a decline of over -56%.
For the yield curve to invert and shift to negative asymmetry, the short-term interest rate will have to increase higher than the longer-term interest rate. Or, the long-term interest rate decrease below the short term. Either way that hasn’t happened yet.
What could cause an inverted yield curve? The end of the yield curve could drive it if investors believe interest rates will be lower in the future. If investors believe long term rates will decrease it may increase demand for longer-term bonds, which consequently lowers yields.
We don’t have to know in advance of what may cause the yield curve to become inverted. We only need to observe that it does. If it does, I would expect a recession. However, the U.S. stock market is the leading indicator for a recession, so we’ll know to expect a recession if the stock market trends down lower than the December low.
Next, I’ll share some observations of leading economic indicators. For me, it doesn’t help with tactical investment decisions, but since the economy is a big global macro topic lately, it’s a good time to review its indicators.
The yield curve hasn’t inverted like it did in December 2006 and August 2000. The yield curve doesn’t suggest a recession anytime soon.
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