What the US yield curve inversion means for your investment portfolio

The US yield curve has received considerable focus in the last few weeks, with widespread commentary on its ‘inversion’. For investors, it’s important to consider what that might mean for the US economy, global growth, and the direction of our Australian dollar against the US dollar.

The US yield curve put simply is the term structure of US interest rates

This effectively is the rates at which the US government can borrow for one month, three months and so on, all the way out to 30 years. Intuitively, investors require a higher interest rate to lend for the long term (for example, 30 years) than to lock up money for say one month. Accordingly, the normal term structure of interest rates is ‘positive’ – i.e. short-term rates are lower than long-term rates.

The cost of borrowing illustrated by the yield curve is dynamic. As expectations for the economy and inflation change, and as the US government changes its policies, the market interest rates change. Comparing how the slope of the yield curve changes over time gives us some insights into what markets are expecting in relation to inflation and the outlook for the economy, among other things.

Occasionally, interest rates at the short end move to be higher than the long end, inverting the curve

This can be from short-term rates rising rapidly, long-term rates falling, or a combination of the two. In particular, market watchers focus on the spread of 10-year US Treasuries (government bonds) against three-month US T-Bills (short-term government bills) and the spread of 10-year Treasuries against two-year Treasuries.

The US Federal Reserve (Fed) recently signalled it will stop raising its cash rate. The market appears to have reacted by buying longer-dated US treasuries, causing long-dated yields to fall sharply, giving rise to the current situation where the yield curve has technically inverted on the 10-year/3-month measure. The 10-year/2-year measure has not inverted at the time of writing.

Market concern about an inverted yield curve is driven by its history of predicting recessions

Historically, an inverted yield curve has proven to be an accurate early predictor of US recessions. 'Early' is important here. Over the last 30 years, the lead time from inversion to recession has been on average about 15 months. The mechanism by which this predictive power operates is less clear. For example, there is correlation between consumer and business confidence and the yield curve shape.

The yield curve is effectively a comparison of short- and long-term expectations. If short-term rates are higher than long-term rates the market is, in effect, saying that current conditions are better than future conditions and economic growth may be lower in the future. In those circumstances, confidence will generally be falling, hence the correlation.

As the world’s largest economy and lending market, the US has strong influence on small economies

In a smaller economy such as Australia, our banks, for example, raise a significant proportion of their funding from overseas US dollar markets. A growing US draws in imports from the rest of the world (excepting trade wars), which in turn encourages those economies to grow and import raw materials from Australia. Conversely, a US recession tends to have a detrimental effect on the global economy and Australia.

Before investors become overly panicked by the yield curve inversion, there are four important points to consider:

1. The curve has only just inverted and has not inverted on all measures

Economic commentators often believe the 10-year/2-year measure is a better indicator as it is less volatile and has given fewer false signals. If it is still this way in a month’s time, then the signal is potentially significant. If not, then it could prove to be markets ‘overshooting’, which likely points to a false signal.

2. There is a time lag from inversion to recession

Historically, asset markets have been strong, particularly equity markets, during the initial period after the curve first inverts.

3. The accuracy of the signal is not 100 per cent

While accurate over the last 50 years there have been false signals in the past. We are loath to say “this time is different” but there are arguments that the unprecedented monetary looseness and experimental monetary policies the world has seen since the Global Financial Crisis may have disrupted this once accurate mechanism.

4. The US economy appears to be in decent shape

It is showing improved wages growth and positive economic growth. We can see few signs indicating recession on the near horizon.

It’s important to remember that geopolitics and world markets are challenging and increasingly complex. In our view, current valuations of a range of financial markets do not appear to provide significant protection against these headwinds and so we retain a cautious disposition. We continue to closely monitor developments in the US and the broader global economy and will continue to regularly debate and re-test the positioning of our portfolios and their ability to deal with the risks we see.

This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward-looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct. Readers should be aware that past performance should not be construed as an indication of future performance and that future returns are not guaranteed.