THE US yield curve has attracted a lot of attention in the past week as longer-term rates have fallen causing a perversion or inversion of the yield curve and eliciting concerns of a weakening outlook for growth and inflation. But what is an inverted yield curve, what caused it and what are the implications for investing?

WHAT IS AN INVERTED YIELD CURVE?

A yield curve is basically a graph that shows the interest rate paid on bonds of different maturity periods (tenors) by a particular issuer or borrower.

The US yield curve, for instance, shows the rates at which the US government can borrow for periods ranging from one month to 30 years.

In normal times, longer-dated bonds are expected to offer higher yields than shorter-term bonds to compensate investors for the increased repayment uncertainty associating with deploying funds for longer periods of time. Thus, a normal yield curve is upward sloping and shows that rates should be progressively higher the longer the time period is.

An inverted yield curve is therefore a perversion of a normal sloping curve and is manifested when short-term rates are higher than longer-term rates producing a downwardly or negatively sloped curve.

WHY DID THE US YIELD CURVE INVERT?

The US yield curve inverted on March 22, 2019 when the 10-year yield fell to 2.44 per cent — below the three-month rate of 2.46 per cent on US Treasury securities.

The last curve inversion was in 2007 and the so-called Great Recession of 2008 -2009 followed soon after.

Investors can therefore be forgiven for their reactions which led to deeper curve inversion over the next few days before normality was returned on March 29th.

An inverted yield curve suggests yields on longer-term bonds may continue to fall, corresponding to periods of economic recession. When investors expect longer-maturity bond yields to become even lower in the future, many would purchase longer-maturity bonds to lock in yields before they decrease further.

The increasing onset of demand for longer-maturity bonds and the lack of demand for shorter-term securities lead to higher prices but lower yields on longer-maturity bonds, and lower prices but higher yields on shorter-term securities, further inverting the curve.

In the lead-up to the inversion on March 22nd, the US Central Bank (Fed) projected no new rate hikes in 2019 (after raising rates four times in 2018). That cast some level of doubt about the health of the US economy at a time when the economies of Europe and China were also slowing and the Brexit debacle was still unresolved.

Fears of a global downturn were further amplified on March 22nd as a result of weaker-than-expected European manufacturing data. Investors then sought the safety of longer-dated US Treasuries causing a plunge in the 10-year yield that day, raising concerns that a recession may be imminent.

WHAT DOES IT MEAN

Historically, the time span between a yield curve inversion and a recession ranges from six months to three years. Even with signals of slowing economic conditions, no one knows for sure if and when a recession will occur.

What the yield curve inversion does confirm, however, is the view that the US economy is likely in the later innings of one of its longest expansion cycles. Investors do not need to panic or overreact at this point.

The next recession may not necessarily be close at hand and Fed policy still appears largely accommodative for the US economy; moreover, the yield curve has since normalised.

Nevertheless, caution should be exercised going forward and investors should also consider reducing any excessive credit risks within their portfolios by adding, for instance, higher quality longer-dated bonds and decreasing lower-quality bonds and/or equities.

Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm .