To put it simply, an inverted yield curve is when long term interest rates are lower than short term interest rates. You might wonder, how is this possible? After all, if you take out a longer term on your deposits, you should get paid more interest, right? Well, not necessarily.
If we take a glance at term deposits today, you might be rewarded with around 2.75%pa for terms up to one year. Looking out to 5 years, you might be offered much the same rate. That could be interpreted as a flat yield curve.
This is illustrated in the chart below which overlays the yield curve for government bonds from different points in time over the last year. Two things can be observed: 1. The red line (being the most recent reading) is slightly inverted out to 5 years at which point longer term rates rise sharply; and 2. Even longer term rates are not that much higher than short term rates, considering how long you are committing funds.
To put it another way, the yield curve is the difference between short term rates and long term rates.
When has the yield curve inverted in Australia? Typically in times of stress. The chart below tells us historically what that gap has been between the 10 year bond rate and cash – currently the difference between cash and the 10 year government bond rate is around 1% – not much. You can also see two times in the past when the gap was negative – the ‘recession we had to have’ in the early 1990’s and the global financial crisis.
Why do yield curves become flatter? It’s not a terrible thing but it does reflect expectations of lower economic growth. That’s okay – an economy isn’t expected to be firing on all cylinders in perpetuity. What is uncomfortable is negative growth i.e. going backwards – an inverted yield curve reflects an expectation of a period of potential negative growth.
When we look at the yield curve in different regions, we can build a picture of future expectations – they are not always right but they do reflect a consensus outlook. The US yield curve also has a strong success rate in predicting a recession.
So what does this mean for your investments? The paper by Quay is with reference to past cycles and provides a view on how equities and property have performed and might be expected to perform. If they are right, global property has a place in portfolios alongside equities to have a more resilient portfolio in downturns. This may be quite attractive if one takes a view that yields will be lower for longer and we are heading into a low growth world over the next few years.
Cover picture- marketwatch.com
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