Can bond yields really predict recession?

-- | 18/09/2019

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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 a greater interest rate for lending money over longer periods to compensate for the fact that uncertainty increases as we look further into the future. By drawing a line between these varying interest rates 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 market can predict the equity market.

This report appeared on 2021 Morningstar Australasia Pty Limited

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