Does the yield inversion really signal a recession?

-- | 02/04/2019

Page 1 of 1

Dan Kemp: You may have recently heard about the phenomena of yield curve inversion and be wondering what this means and how it may affect your investments.

The yield curve simply describes the interest rate an investor can obtain by lending money over specific time periods. Investors typically demand greater interest rates for lending money over longer periods to compensate them for the fact that uncertainty increases as we look further into the future. By drawing a line between these varying interest rate on a chart, a “curve” typically appears and hence we talk about the “yield curve”.

Yield curve inversion is a rare situation where the cost of borrowing money over the long term is lower than the cost of borrowing over the short term. This typically indicates that investors expect significantly lower interest rates and/or lower inflation in the future. For this reason, yield curve inversion often indicates a future recession and is used by some as a signal for investors to take less risk.

However, investing is not quite that simple. If there was an entirely predictable way of forecasting recessions, the impact of that recession would be almost immediately reflected in asset prices, reducing the benefit of reacting to the signal.

The challenge for investors is that the future is probabilistic rather than deterministic and we need to consider a range of potential outcomes and their likelihood rather than a single path. This is, of course, difficult to do, not least because as humans we tend to overweight the likelihood of more vivid outcomes and underweight the probability of less interesting paths. However, by considering a range of possible outcomes and assigning probabilities to each, we have the best chance of understanding the impact of future events on a portfolio.

Finally, we need to remember that the economy is not the same as the capital markets. Making accurate forecasts about the former may not help you create returns from the latter. As long-term valuation-driven investors, we believe that the price you pay for an asset is the most important determiner of future returns, whether or not the bond markets can predict equity returns.

This report appeared on www.morningstar.com.au 2019 Morningstar Australasia Pty Limited

© 2019 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written content of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.