Recession Ahead? An Investor’s Guide to the Inverted Yield Curve

An old joke says that the economists have successfully predicted nine out of the last five recessions. To be fair, recessions are hard to predict. Stock markets sometimes fall sharply in anticipation of a recession – generally defined as two consecutive calendar quarters (six months) of negative economic growth – only to have raised a false alarm.

What has a rather better forecasting record, though, is the yield curve in government bond markets. This seemingly arcane graph of bond yields across the terms over which governments borrow is now inverted, which means it’s signalling a recession in major advanced economies, like the US, Eurozone and the UK.

In the interests of understanding what to expect from your investments, I think it’s a good idea to understand what the yield curve is and why it’s signalling recession. Then you can decide how to react. Diversifying the portfolio across high-quality investments is the typical answer.

Explaining the Yield Curve and Its Uncanny Forecasting Powers

The yield curve is a curve on a graph in which the income yields of government bonds are plotted against the length of time they have to run to maturity – typically from three months to 30 years. In normal economic periods, the yields at the shorter-term end of the curve are lower than those that have longer to run to maturity, because they are subject to less uncertainty. But, occasionally, the yields at the short end exceed those at the long end: this is an inverted yield curve and it has a remarkably good record for forecasting recessions, which generally follow within 6 to 24 months.

In early July, the US treasury market hit its deepest inversion since 1981; a time when Fed Chairman Paul Volcker was battling to quell inflation. Things aren’t that different today, and the US, Eurozone and UK yield curves reflect financial markets’ concerns that stubborn inflation will force central banks to tip economies into recession.

So, what’s a prudent investor to do? If professional economists are so bad at forecasting what’s likely to happen, especially at confusing times like this, what hope do the rest of us have?

The approach is normally to diversify the portfolios to spread the risk and avoid taking a bet on any single outcome. When doing so, it might also be a good idea to retreat to high-quality investments: the kind that are in a robust position to weather any recession.

It’s unclear whether the inverted yield curve’s prediction of a recession will come to pass. But the investors could rely on diversification to reduce risks.