Understanding the inverted yield curve

How and when should investors respond to an inverted yield curve?

Investors know there are no reliable ways to predict consistently how the share market will move. That does not mean investors should ignore indicators like an inverted yield curve. But, take a little time to understand what such signs mean and plan a response before following the herd’s charge towards the cliff.

Yield Curve Redux

A ‘yield curve’ is a line drawn between the rates of interest paid for different maturities (3-months, 2 and 10 years for example) on similar debt contracts (debt issued by the Government for example).

Debt investors earn interest paid by the debt issuer. Typically, debt investors demand a higher rate of interest before agreeing to lock-up their money for longer. Therefore, the yield curve usually slopes upward with short-term interest rates being lower than long-term rates.

A yield curve is ‘inverted’ or downward sloping when short-term interest rates are higher than long-term rates. Understanding what causes the yield curve to change shape and what it means is not always straight forward, expectations play a part.

If investors expect central banks to cut interest rates, in response to an economic slowdown, for example, they might buy more long-term debt to lock-in the prevailing interest rate. If more investors want to buy long-term debt, the issuer of that debt won’t have to pay as much interest to attract investors. Other expectations also influence interest rates, for example future inflation and global economic activity.

Experience Counts; Sometimes

Researchers have noted that the yield curve for American Government debt has inverted before every U.S. recession since 1955¹. This simple statement is more complicated than it appears.

• There is no indication of the time between the yield curve inverting and the subsequent recession; some times it was months, other times years.
• There is no indication of the depth or length of any subsequent economic slowdown – some were short corrections, not protracted recessions.
• That two events occur around the same time is not the same as saying the first event caused the second event.
• Other unique factors could be influencing today’s yield curve shape, for example, central banks buying back government debt (called quantitative easing).
• There is little evidence of a similar link between the Australian Government debt yield curve and Australian economic activity.

In short, investors may not find an inverted American yield curve to be particularly helpful indicator of how the Australian share market might perform. But, it can be hard to ignore the flood of concern about an inverting yield curves.Before any investment decision, investors should check for their own inherent biases. It is easy to anchor on the first information received. Once anchored, investors tend to over-emphasise additional information that supports the ‘anchor’ while ignoring other crucial but contradictory information.

Defence Planning

A decision to rebalance a portfolio should align with each investor’s financial goals and timeframe. If investors do decide to rebalance, the questions become what and how.

What to invest in depends on each investors’ risk tolerance. If the inverted yield curve is the market’s way of saying it expects an economic slowdown, it may be worth looking at defensive shares, for example, infrastructure or utilities or an actively managed fund.

The question of how to rebalance is equally essential. For example, selling an existing investment could realise a capital gain that might be taxable. The predicted economic slowdown might not eventuate or maybe shallow with little impact on the share market. Investors who sell now might have to buy back later as the economic outlook becomes more apparent.

In these circumstances, a margin loan facility may be a helpful tool. Suitable investors can use existing investments, without selling, to rebalance a portfolio. Investors have time to assess their financial goals, take in more information about the economy and expected share market performance over their investment timeframe and make planned adjustments to their portfolio.

If you have any questions or would like to discuss your loan account, please get in touch with your Relationship Manager, or contact Leveraged on 1300 307 807.

This information is correct as at 2 September 2019.

¹ Federal Reserve Bank of San Francisco (FRBSF), Economic Letter, 5 March 2018