In this article, we are going to see the meaning of an inverted interest rate curve, why it occurs, what types there are, how it is interpreted, what is its great importance and how the markets behave after it.
Meaning of the inverted interest rate curve
Common sense establishes that lending in the long term almost always tends to be a more interesting investment in terms of performance and profitability than lending in the short term, among other reasons, because the longer the time elapses, the greater the possibility of some negative event occurring.
This is something obvious. If we compare 10-year and 30-year bonds, nobody doubts that unfavourable things can happen in a 30-year period with a higher statistical probability than in a 10-year period. For this reason, typically, the yield on a 30-year bond is greater than the yield on a 10-year bond.
An ascending or positive curve occurs at times of expansion of the economy, with GDP growing 2-3 quarters in a row, creating jobs and increasing consumer confidence. When it is said that the yield curve is inverted, it refers to the fact that the yield of short-term bonds is higher than that of bonds that have a longer term.
Even if the bonds’ yield of different terms is identical or very similar, we would have a flat or sideways yield curve, practically linear. In this case, the state pays the same for borrowing or asking for more money for six months than ten years. This type of curve is very unusual.
Why does the yield curve invert?
We have seen that a yield curve inversion occurs when the yield on short-term bonds is higher than that on longer-term bonds.
The reason why the yield curve inversion occurs is simply due to a lack of confidence in the future of the economy, the fact that uncertainty fears of not knowing what is going to happen or fearing the worse (the possible arrival of an economic crisis, a recession, etc.)
Thus, it is a kind of “anomaly” because investors do not have confidence in the economy and demand more significant financial compensation from the issuer of public debt in the short term.
Why is an inverted yield curve so important?
As I have previously pointed out, when we are facing an inverted rate curve, it means that there is a lack of confidence in the future that is coming. Uncertainty takes over the emotional sentiment of investors.
And no wonder, if history has taught us anything over time, the appearance of an inverted interest rate curve is a fairly serious and reliable sign that an economic recession is approaching for the country in question.
I insist on what is reliable, more than anything, because in the last 52 years, it has practically been like that. It warned of the arrival of both recessions. And another piece of information that is broader in time is that prepared by the San Francisco Reserve in a report in which it says that in the last 60 years, we have seen ten inversions of the curve and that it always warned of a coming recession.
But when it comes to this issue, an inverted yield curve presents both good news and bad news:
- The good news is that it is a solid tool as a warning or signal that a recession in the economy is coming.
- The bad news is the time that elapses between the inversion of the curve and the arrival of the recession since we are talking about one or two years.
The most followed yield curve in the world is that of the United States and can be seen on the Stockcharts website. In the case of wanting to follow the curve of Europe, it can be done on the website of the Central European Bacchus.
By the end of 2022, the spread between the 10-year (3.81%) and 12-month (4.72%) bond yields could reverse 91 basis points, rapidly approaching a percentage point. That has only been seen (100 basis points or more) in the summer of 1973 and 1974 and also in late 19 79-early 1980.
Which yield curves are the most important?
Among the different yield curves, we can highlight two as important and relevant:
- The curve that runs between 3-month bonds and 10-year bonds: The average time span from the inversion of the yield curve to the onset of the recession was one year and seven months.
- The curve of the 2-year bonds and the 10-year bonds: this spread is undoubtedly the best to follow. In fact, it is usually the most followed by investors. Suffice it to say that taking the last five recessions was beneficial because it always warned of the arrival of the recession. In this case, the average notice period was one year and nine months, at least eleven months.
How the Stock Market behaves with an inversion of the curve
An inverted curve is not a positive development and, therefore, would not favour equity markets. But the reality is quite the opposite. If we take the most crucial stock index in the world, the S&P 500, we can see that the curve’s inversion not only did not cause it to fall but rose an average of 8% over the next eleven months. Only in one case did the S&P 500 not continue bullish, which was in 1973.
Another critical issue is which sectors are benefited and which are not. Typically, an inverted curve is followed by a long period of rate hikes -by the central bank-. Consequently, it is essential to know how interest rates affect investments in the stock market.
In short, an inverted interest rate curve warns -and quite precisely- of the risk of stagnation and recession in the medium term. However, it is accompanied by increases in the stock market since the markets begin to discount how much it will rise once the stage of economic recession passes.