Is the yield curve reliable or not?

The yield curve is grabbing a lot of headlines at the moment, and not all of them are encouraging ones for investors (except those investors who are sat on dollops of cash waiting for an economic downturn and a chance to buy assets more cheaply after a sell-off).

In fact, there are four types of yield curve, using the difference in yield between 2- and 10-year government bonds as our benchmark. Normally, the yield on the 10-year paper would be higher than that of the 2-year, as investors demand compensation for the additional 8 years to maturity, which means there is more time for things to go wrong (inflation, interest rate increases or default being the main three dangers).

  • Normal. Here yield on the 10-year paper is higher than that of the 2-year. Investors demand compensation for the additional 8 years to maturity, as this means there is more time for things to go wrong (inflation, interest rate increases or default being the main three dangers).

  • Steep. In this case, long-term yields rise more quickly than near-term ones, as investors price in an acceleration in economic growth and interest rate increases. Investors fear being locked into low rates and demand greater compensation for owning the longer-dated paper.

  • Flat. This is where the bond market is unsure how to proceed. Yields on 2- and 10-year papers are the same as the economy transitions from downturn to upturn or upturn to downturn.

  • Inverted. Here, bond markets fear an economic slowdown or recession and the yield on longer-dated bonds drops below that of the shorter-term paper. This happens because investors price in future interest rate cuts in response to the slowdown and a drop in coupons on bonds issued by governments in the future.

  • “Right now, all of the talk concerns the US yield curve and how it is inverting.”


    Right now, all of the talk concerns the US yield curve and how it is inverting. The yield on US 10-year Treasuries is, at the time of writing, 1.577%, compared to 1.569% on 2-year Treasuries (and in early August, the 10-year yield was nearly 0.10% below that of the shorter-term issue).

    This is prompting much hand-wringing, because the recessions that began in 1980, 1982, 1990, 2000 and 2007 were all preceded by an inversion of the yield curve.

    Recent US recessions have all been preceded by yield curve inversions

    Source: Refinitiv data

    The prospect of a recession is a worry for those investors exposed to so-called ‘risk assets’ like equities and commodities, as it will hit their earning power and demand for them respectively, to the possible detriment of their valuations and prices.

    Enter the banker

    However, all may not be lost, for two reasons.

    “Although every recession has been preceded by an inverted yield curve, not every inversion has preceded a recession.”


  • First, although every recession has been preceded by an inverted yield curve, not every inversion has preceded a recession. In plain English, there have been false signals. Inverted curves in 1994–95 and 1998 did not see a downturn follow, for example.

  • Second, Japan’s experiences since 1990 suggest the yield curve can be a poor predictor of economic activity. In the 1980s, it wasn’t bad (calling the downturn of 1985 and the 1990 peak rather accurately), but it has been pretty hopeless since then.

  • The yield curve has given little useful guidance on Japanese growth for some years

    Source: Refinitiv data

    This is not to say the Japanese experience is entirely encouraging. After all, it suggests that the yield curve stopped being useful pretty much as soon as the Bank of Japan (BoJ) got stuck into zero-interest-rate policies (ZIRP) and Quantitative Easing (QE) in the early 1990s, as it responded to the bursting of the country’s debt-fuelled stock market and property bubble. In other words, central bank manipulation of the bond market may have dulled the indicator’s edge.

    “Central bank manipulation of the bond market may have dulled the indicator’s edge.”

    Stock market signs

    But even if the bankers can muddy the bond market waters, can they actually stave off a downturn and a fall in equity markets (forever)?

    In Japan, the yield curve has become of progressively less use when it comes to trying to read where the Nikkei 225 stock index may go. If anything, a steeper yield has signalled lower stocks (as the BoJ tried to raise rates and step back from QE) and a flattening one has foretold higher share prices (as the BoJ stepped on the monetary gas once more).

    The yield curve has given little useful guidance on Japanese stocks as well

    Source: Refinitiv data

    We therefore have to see whether Mark Carney (and his successor) at the Bank of England and Jay Powell at the US Federal Reserve are as successful in bending markets to their monetary will.

    Inverted yield curves in 2000 and 2007 helped to call the top for the FTSE All-Share index – and the UK yield curve is just inverting again right now.

    An inverted yield curve warned of share price strife in the UK in 2000 and 2007

    Source: Refinitiv data

    “Even when the yield curve was wrong on the economy in 1994–95 and 1998, financial markets were very volatile.”


    An inverted curve also warned of trouble in the US in the early 1990s, 2000 and 2007. And even when the yield curve was wrong on the economy in 1994–95 and 1998, financial markets were very volatile, thanks to the Mexican peso devaluation crisis of 1994 and the Asian and Russian debt bombs and devaluations of 1997–98.

    An inverted yield curve has often been a bad sign for US stocks

    Source: Refinitiv data

    So even if the bankers can fend off a recession, who is to say that investors should put blind faith in them when it comes to share prices?

    AJ Bell Investment Director

    Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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