Graham Secker, chief European equity strategist at Morgan Stanley, explains why the yield curve is used as an indicator of economic health and considers the implications of an inverted curve for investors
What are yield curves and how should they be interpreted?
A yield curve is a graphical representation of yields on bonds of similar quality against their duration. It is used as a guide to economic activity because, in a normal cycle, interest rates are higher the further out you go along the curve, as lenders are compensating for the higher risk profile of lending money over a longer period in the form of capital losses or inflation, for example.
The yield curve inverts when the interest rate lending long falls below the interest rate lending short, which indicates that investors are increasingly nervous about the future growth outlook.
If ten-year yields are below two-year yields, this is historically a reliable indicator that the economy is slowing down.
What is a normal yield curve and why is it usually upward sloping?
There is no ‘normal’ yield curve as such. If we look at the US yield curve over the past 30 years, the maximum steepness of the curve (the gap between ten-year yields and two-year yields) is around 250 basis points or 2.5 percentage points. At its lowest point it tends to stop between zero and minus 50 basis points.
The average is somewhere between 100 and 150 basis points, but the curve would have been at this level for less than 50% of the time over that 30-year period.
The US yield curve tends to move in sweeping cycles – six years ago it was at 250 basis points, and since then it has fallen fairly consistently, although it recovered in the final quarter of 2019.
What is an inverted yield curve and why is it a cause for investor concern?
The theory is that when the yield curve is inverted, so that long-term interest rates are lower than short-term interest rates, it indicates that bond investors expect central banks to cut rates, which they would only do if the economy was deteriorating.
The yield curve is the only leading indicator that has correctly predicted just about every recession over the past 40 to 50 years – it tends not to generate false signals. An inverted yield curve doesn’t mean that a recession is imminent, but it suggests that over the next 12 to 24 months there is a high chance of a downturn.
The yield curve recently inverted. What led to this?
The yield curve was in and out of inversion regularly for much of 2019. The question in the market is whether this means growth is slowing a little or a lot.
Some investors suggested that quantitative easing and negative interest rates had skewed the signals from the yield curve and that these signals were not as reliable as they had been in the past.
The inverted yield curve is said to be a harbinger of recessions, but is it also a cause of them?
There is no definitive answer to the question of whether yield curve discussions become a self-fulfilling prophecy – the average person does not trim their spending because the yield curve is inverted.
About the expert
Graham Secker is chief European equity strategist at Morgan Stanley.
What we can say is that cutting interest rates can be a double-edged sword in that it reduces borrowing costs and puts more cash in consumers’ pockets, but it also encourages consumers to save rather than spend because they see it as a warning that times are getting harder.
What does an inverted yield curve mean for GBP-based investors?The UK yield curve is close to zero – ten-year UK gilt yields are currently 75 basis points and two-year bond yields are 105 basis points. The challenge for GBP investors is that if we look at global bond markets, bond yields generally move in a similar direction.
Most of our clients spend more time looking at the US yield curve because this tells them more about the global economy. Around 80% of the FTSE 100’s revenues come from outside the UK, so the UK yield curve is of less relevance to those large companies and most relevant to other corporates with more UK exposure.
A large part of the bond market is offering negative returns at the moment, yet investors are still investing. Why is this the case, and where are they putting their money?
Investing in bonds with negative yields may seem strange, but it needs to be considered in the context of very low or negative European interest rates. With the latter at minus 50 basis points, it can make sense to invest money in bonds if they yield more than this – for example, banks could borrow money at minus 50 basis points and buy a bond yielding minus 25 basis points and make a profit. Banks also need to maintain substantial bond holdings for regulatory purposes irrespective of their valuation.
This article was originally published in the February 2020 print edition of The Review.
The full print edition PDF is now available online for all members.
All CISI members, excluding student members, are eligible to receive a hard copy of the quarterly print edition of the magazine. Members can opt in to receive the print edition by logging in to MyCISI, clicking on My account, then clicking the Communications tab and selecting ‘Yes’.
Once you have read the print edition, keep coming back to the digital edition of The Review, which is updated regularly with news, features and comment about the Institute and the financial services sector.
Seen a blog, news story or discussion online that you think might interest CISI members? Email bethan.rees@wardour.co.uk.