The gilt yield curve is now upward-sloping. As I write, 10-year yields, at 0.2 per cent, are above three-month money rates and two-year yields. History suggests this is good for equities.
Since 1995, for example, the All-Share index has risen by an average of 23.8 per cent in the three years after the curve has sloped upwards – when 10-year yields have been above three-month rates. But it has fallen by an average of 6.7 per cent in the three years after it has been inverted. This relationship has continued to hold recently. 10-year yields fell below three-month rates in the summer of 2019 – which, we now know, presaged this year’s market fall.
There’s a reason for this. To see it, ask why anybody would want to hold cash if longer-dated gilts pay a higher yield. It’s because they expect interest rates to rise. Such a rise would cause capital losses on gilts, but also the chance to reinvest cash at a higher rate in future. And in what circumstances would investors expect rates to rise? Those in which the economy is doing well. By the same logic, an inverted yield curve means investors expect falling rates and a recession.
Such expectations are often correct. Charles Goodhart, a former chief economist at the Bank of England, has pointed out that inverted yield curves have indeed led to recessions.
Because a stronger economy means a rising equity market and a weaker economy a falling one, so the yield curve predicts equity returns.
You might wonder: if bond investors see recessions and expansions coming, why don’t equity investors do so and so price these into equities in advance?
One reason is that even if they do foresee booms and slumps, they don’t foresee that these will cause their appetite for risk to change. As a result, equities can rise as the economy grows simply because willingness to take on risk also grows.
All of which poses a question. If bond markets can predict equity returns, might they also predict other assets?
In theory, they should. To see why, think about gold. It pays no income. Which means that its price should be low when bond yields are high because in such circumstances we are making a big sacrifice when we hold gold. Which in turn means that gold’s price should rise when bond yields fall and fall when bond yields rise.
If the yield curve predicts changes in bond yields, therefore, it should also predict changes in the gold price.
So does it?
Yes, sort of. Gold has done amazingly well after inverted yield curves, rising by an average of 48 per cent in US dollar terms in the three years after such inversions since 1995. But it’s also done okay after the curve has been upward-sloping, rising by an average of 14.4 per cent in the subsequent three years.
This, of course, just tells us that gold has done well in most circumstances in the last 25 years, because bond yields around the world have trended down, thereby reducing the opportunity cost of holding gold and so raising its price. This downtrend has offset the cyclical effect of yield curves, causing gold to deliver good returns even in times that should have been bad for the metal.
Which poses a danger. What if the long downtrend in gilt yields is now over? If so, then gold’s price could actually fall if yields rise as the yield curve predicts.
Now, this is not a case for abandoning the metal. For one thing, the yield curve is only slightly upward-sloping and so points to only moderate rises in yields. Such an opinion is plausible. There are powerful forces behind the secular stagnation that have given us low yields – such as a lack of investment and innovation, ageing population, shortage of safe assets and downward trend in profit rates. These won’t disappear quickly.
And for another thing, the case for holding gold is not that it offers great returns. Instead, the metal should be regarded as insurance against some types of bear market in equities – those caused by fears of slow growth or increased risk aversion, the sort of events that see bond yields fall. The need for such insurance hasn’t entirely disappeared.
Yes, the yield curve is telling us to bet on equities and against gold. And one message of this year’s events is that we should take the yield curve seriously. Equally, though, we should not bet everything upon it.
