Mark Lister, 11 March 2022

Interest rates are very much in focus at the moment, with our Reserve Bank having just increased its policy rate again and the Federal Reserve in the US expected to do the same this month, despite the conflict in Ukraine. There’s one particular piece of the interest rate puzzle I keep a close eye on.

The yield curve is a line on a chart that plots interest rates or ‘yields’ over different maturity dates. In the past, the relationship between short and long-term rates has proven to be a good indicator of storm clouds on the horizon.

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Under normal circumstances, it is upward sloping. Long-term rates are higher than short-term rates because investors demand greater compensation for locking their money up for lengthier periods of time.

However, when bond investors see lower growth (or a recession) ahead, they become more comfortable accepting lower interest rates for those longer-term bonds.

An increasing willingness to accept lower interest rates several years into the future can sometimes see longer-term interest rates fall below the prevailing short-term rates, and the yield curve becomes ‘inverted’, or downward sloping.

This is important for share investors, because bond markets are traditionally quite good at sniffing out trouble.

Substantial falls in sharemarkets are rare outside of recessions, as they usually require a large decline in corporate earnings, and that typically involves a contracting economy.

Since 1960, there have been nine US recessions. During each of these, the S&P 500 sharemarket index has fallen sharply, by an average of 33 per cent.

The US yield curve has inverted ahead of every single one of these. On average, it’s done so 14 months ahead of the onset of recession.

The shortest lead time was four months, back in in 1973, while the longest has been about two years.

That was before the GFC, when the yield curve inverted in December 2005. The S&P 500 peaked in October 2007, and the US fell into recession two months later.

There was one false alarm in 1966, but aside from that the yield curve has a perfect record since 1960.

Interestingly, it even inverted in August 2019, six months ahead of the COVID-induced recession (and the associated major sharemarket decline) of 2020.

The predictive powers of the yield curve are unlikely to extend to pandemics, so maybe that was just coincidence.

However, some would argue the ingredients for a recession were already building at that time, and one would’ve followed sooner or later, pandemic or not.

This brings me to where we’re at today. As is the case in many countries, the US central bank is poised to crank up interest rates to try and bring down surging inflation.

That’s seen the US two-year Treasury yield increase to 1.5 per cent, up from just 0.1 per cent a year ago. Longer-term interest rates have increased too, but not nearly as much.

The gap between the two-year rate and the ten-year rate is now less than half a per cent. The good news is that there’s still a gap. The bad news is that 12 months ago the difference was about three times that.

The yield curve is still upward sloping, but not by much. If current trends continue, there’s every chance it inverts within the year.

Some would argue that in an age of increasing central bank influence on interest rate markets, its usefulness as a predictor has diminished.

That could be true, but I’m inclined to show the yield curve a little more respect.

The alarm bells aren’t yet flashing red, and an awful lot can change in a matter of months, but it’s definitely worth keeping an eye on.