Inverted Yield Curve
The inverted yield curve predicts a recession with remarkable accuracy.
Since 1955, the inverted yield curve happened nine times. Each one predicted the upcoming recession.
So what is the inverted yield curve?
This phenomenon occurs when short term bonds provide a higher return than long term bonds.
But what does this actually mean?
Bond Yield Curve Explained
Imagine that you want to lend $1,000 to a company, with the expectation you will receive it back with interest.
The first company offers you a return of 5% a year for the next 5 years. Alternatively, the second company offers you a return of 4.5% a year over the next one year.
Which do you take?
Investors expect to receive a higher return in exchange for lending capital for a longer period of time. Therefore, time costs money.
Therefore, it is adviseable you take the option that decreases your return in exchange for receiving your cash back faster.
This relationship between time and return (yield) is called the bond yield curve. Here is an example of the standard yield curve.
Inverted Bond Yield Curve Explained
Now imagine the two company options were:
- A: Offers 5% return for 1 year
- B: Offers 4% return for 10 years
This is not a typo, you are reading it right. Company B is offering to pay you less and locks up your money for a much longer time.
Who would take this deal? No one.
The phenomenon of higher short term bond rates over longer term bonds is called the inverted yield curve. This is what it looks like.
One cause of this inverted yield curve is when the Federal Reserve is hiking interest rates. This is occurring in the latest economic cycle.
The problem with the inverted yield curve is that corporations have difficulty raising capital to finance their operations.
This leads in a slow down of sales and profitability, resulting in a weakening economy.
Now that you understand the concept of the inverted yield curve let’s pull up some examples.
Inverted Yield Curve Case Studies
An inverted yield curve has signaled a recession every time since the 50’s.
More importantly, a recession occurs approximately 12 to 24 months after the inverted yield curve inverts.
Let’s take a deeper look at the last three major recessions:
- 2008 to 09 – Housing bubble
- 2001 – Technology crash
- 1980 to 82 – Federal Reserve rate hike crash
#1: Inverted Yield Curve – The 2008/09 Housing Bubble
This recession was the worst one since the 1929 depression.
In the chart below you can see the yield curve in black versus the broad stock market, the S&P 500.
You can see that the yield curve began to slop negative well before the housing bubble burst. However, this is just a declining curve and it did not actually invert until 2007. Just over 12 months later the stock market crashed.
#2: Inverted Yield Curve – 2001 Technology Bubble
Next let’s take a look at the yield curve behavior during the technology bubble market crash.
You can see that the yield curve began to decline in late 1998. In 2000 the yield curve officially inverted, and the stock market crashed just over a year later.
#3: Inverted Yield Curve – 1980/82 Fed Rate Hike Crash
This last example is especially interesting when you consider what the Federal Reserve has been doing lately. Of course, there is one big difference back then.
The Fed raised rates aggressively to combat increasing inflation. In this latest rate hike cycle inflation has been flat.
GDP was negative for 6 of the 12 quarters. In the second quarter of 1980 the GDP crashed to a low of -8.0%; the worst quarterly decline since the 1929 great depression.
Was the inverted yield curve able to forecast this event?
I could not pull the inverted yield curve data that far back on TradingView, however, the answer is still a resounding yes. It accurately predicted the coming market collapse over 12 months prior.
Inverted Yield Curve: Conclusion
While this tool has remarkable predictive qualities, you must remember that it does not predict the actual timing.
Before a recession occurs, the sentiment is at it’s maximum optimism. Stock markets will be roaring higher, and it is very dangerous to fade the momentum.
Just like shaving against the grain exposes you to the risk of being cut.
The inverted yield curve has an average recession prediction of 12 to 24 months. The stock market can move significantly higher before the beginnings stages of the cycle.
Therefore, it is always best to invest with the momentum and create trading / investing qualifiers that include a diverse set of criteria.
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As always, manage your risk and trade like a TRADEPRO.
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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.