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Yield curve warning

The inverted gilt yield curve points to low returns on equities and a heightened risk of recession
August 20, 2019

The gilt yield curve is now inverted, with 10-year yields below three-month interbank rates. History suggests this is a warning that recession is very possible.

For example, the curve was inverted in 1973, 1979, 1988, and in 2006. On all these occasions a recession followed a few months later.

It is not, however, an infallible indicator. The curve also inverted in 1970, 1985 and 1997 and yet the economy continued to grow. And the lags between inversions and recession – even when they exist – can be long. The curve inverted in 1988 and 2005, it on both occasions we didn’t get a recession for another two years.

On balance, though, the inverted curve is a warning sign. Since 1970 manufacturing output has on average not grown at all in the three years after we’ve seen inverted curves, whereas it has risen by an average of 2.8 per cent in the three years after we’ve seen upward-sloping curves.

Equity investors should worry about this. Because shares tend to do badly when the economy does, an inverted curve warns us to expect lower returns. Since 1987 the All-Share index has risen by only 5.8 per cent on average in the three years after the curve has been inverted, compared with an average rise of 27.6 per cent in the three years after the curve has been upward-sloping.

This of course implies that market falls are much more likely after the curve has been inverted. Since 1987 there have been 157 months in which 10-year yields have been below three-month interbank rates. In the following three years the All-Share index has fallen 67 times. In the three years after the curve has been upward-sloping, however, the index has fallen only 15 times out of 198 observations. Falls are therefore more than five times more likely after the curve has been inverted than after it has been upward sloping.

My table shows that some sectors are much more sensitive than this to the shape of the curve. IT stocks, for example, have risen by an average of 81.6 per cent after the curve has been upward-sloping but only 8.5 per cent after it has been inverted. It is cyclical or sentiment-sensitive sectors whose returns vary the most with the yield curve. By contrast, the only two FTSE sectors that have done better after inverted curves than after upward-sloping ones have been defensives: food retailing and tobacco.

How the yield curve predicts returns
Price change in the three years after
 Inverted curveUpward curveDifference
All-Share index5.827.621.8
Information technology8.581.673.1
Construction5.331.926.6
Aerospace & defence1.848.146.3
Support services1.137.336.2
Travel & leisure-3.247.150.3
Food retailers16.113.5-2.6
Tobacco47.038.0-9.0
Based on monthly data since 1987

History, therefore, tells us that we should cut our exposure to equities, and especially to the less defensive ones.

Which poses the question: how good a guide is history?

It is futile to discuss the likelihood of a recession simply because – as the IMF’s Paraksh Loungani has shown – economists have consistently failed to predict them in the past. Sure, the yield curve isn’t a perfect predictor. But it has a better track record than economists.

There is, however, another reason for optimism. Previous inversions of the curve were due in large part to rises in short-term interest rates – and tighter monetary policy is obviously potentially recessionary. This time, though, is different – yes really. The curve has inverted not because short rates have risen but because long ones have fallen. Does this predict recession?

It might. An inverted curve is a sign that markets expect short rates to fall. Why might they expect that? Because they expect the economy to do badly. If there is wisdom in crowds, therefore, an inverted curve points to recession even if it is due only to long rates falling.

But is there wisdom in crowds? It could be that we are seeing is not wisdom but rather the blind leading the blind, an information cascade. Gilt yields might have fallen because investors fear that others fear recession. In this sense, we might be in a positive feedback loop, whereby falling yields lead to further falls. The same such loop might well have caused equities to become too cheap, because selling of them has triggered further selling.

In the US, another such loop might be operating. Because investors know that the Fed believes an inverted curve is a signal of recession, such inversions cause them to expect cuts in interest rates which in turn leads to even lower long rates and to deeper inversions. Because gilt yields are correlated with US yields, this process drags down yields here.

For equity investors this raises a hope – that perhaps this yield curve inversion won’t lead to bad returns simply because the bad news is already in the price, and in fact might even have pushed share prices down too far.

This, however, is only a hope. While it’s possible that investors are already anticipating lower earnings it’s less likely that they are fully anticipating that a recession will reduce their appetite for risk: as Harvard University’s Matthew Rabin and colleagues have shown, we often project our current tastes into the future and so underestimate the extent to which they will change.

On balance, therefore, the inverted yield curve is a reason for equity investors to be concerned, but it is not a reason to dump shares heavily – yet.