Is the Yield Curve Pointing to the Next Recession? A Look at Advanced Investment Strategies for New Investors

When investing, many investors pay attention to common economic indicators to determine the direction of the market. For example, they look at statistics like the unemployment rate, inflation rate, and GDP growth rates.  While these are good indicators, they are not particularly helpful for anticipating market movements.  One of the anticipator indicators (as I call them) that I look at is the yield curve, a measurement that compares the yields of similar-quality bonds against their maturities, ranging from shortest to longest.

In today’s article, I’ll be going over theories and strategies that many novice investors have not been introduced to and identify the sectors that investors should pay attention to for buying opportunities.

What is Inversion of the Yield Curve?

The yield curve can take three primary shapes. If short-term yields are lower than long-term yields (the line is sloping upwards), then the curve is referred to a positive (or “normal”) yield curve. If short-term yields are higher than long-term yields (the line is sloping downwards), then the curve is referred to as an inverted (or “negative”) yield curve. Finally, a flat yield curve exists when there is little or no difference between short- and long-term yields.

Investors should pay attention to inverted yield curves, which are relatively rare events. Please refer to the graph below:

This is how a regular yield curve should look like.

Before we get to an inverted yield curve, flattening is a concern and it looks like this.

Why is yield curve inversion important?

Yield Curve inversions have preceded U.S. recession with incredible accuracy. Specifically, it had preceded the past seven. In simple terms, it says that the economy is strong right now and in the near future (short-term) to sustain a rising interest rate environment. In addition, it also predicts that the economy has to reduce the interest rates in the future (long-term) to stimulate the economy again.

What is the primary driver of an Inversion?

Historically, it is the short-term end of the yield curve that explains majority of the yield curve moments. Central Banks have been raising rates and, as a result, is driving the yield curve to move higher in the short-end.

The primary reasons that cause Central Banks to increase interest rates are:

• Core Inflation – Unexpected higher inflation may lead to the economy growing too quickly and Central Bank needs to slow it down and control it.
• Neutral Rate – Central Bank prefers to have the interest rate at the neutral rate level. This is because that is when the Real GDP is growing at the long-term trend rate, and when inflation is stable.
• Growth of Unemployment – As the unemployment rate declines over time, the economy is stronger and has the ability to handle a higher interest rate. In other words, when the unemployment level declines, more people are employed and have the ability to make their debt obligations.

Why should we be concerned?

Specifically in the United States, the inflation rate and unemployment rate are both at desired levels at 2% and 4% respectively. As a result, the probability of a few more rate hikes in 2018 are relatively high because The Fed has the incentive to increase the rates back to the neutral rate level. The more rate hikes, the more likely the yield curve flattens, and the more likely it would invert.

Where are the opportunities to invest?

It isn’t the end of the world when the trajectory of interest rates is increasing. We can still find opportunities to make some gains and potentially outperform your term deposit or savings account returns.

• Financials – As the spread in margins for banks and insurance companies increase due to higher interest rates, their profits would increase and would lead to higher stock prices.
• Consumer Staples – These are companies that provide products that consumers need to use whether the economy is good or bad. As such, they tend to less volatile and more protected against market downturns.
• Short Duration Bonds – For investors that prefer to receive a periodic income and remain conservative, they may want to consider investing into short duration bonds. As we are aware, there is an inverse relationship between bond prices and interest rates. The rising interest rates would lead to lower bond prices. By having shorter duration bonds, the impact of declining prices would be minimized.

The above-mentioned areas are identified to help you earn some returns in times of volatility. What about protection? There are definitely strategies that I can implement to be more defensive and protect against the downside. I would love to elaborate on here, but it would be a long essay. So, if you are interested, please feel free to connect with me. I would love the opportunity to further discuss.

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Joseph Tang is an Investment Advisor at BMO Nesbitt Burns and holds the Chartered Financial Analyst (CFA) Designation. He has been working in the financial industry for over a decade. His passion is to provide comprehensive wealth management strategies and build customized investment portfolios for his clients. He firmly believes in fundamental investing and in active management of assets by adapting to constant changing economic conditions. Joseph Tang can be reached through his email address: [email protected] 

Read more articles from this author:

For New Chinese Investors in Canada – RRSP vs TFSA 

Fundamentals of Investing in Equities

Deriving Passive Income in your Portfolio

7 Major Risks of Investing in Bonds

6 Common Myths Preventing You from Investing Correctly

It’s Been a Wild Couple of Weeks for Investors – Trump Tariffs and Facebook

Integrating Small Cap Equities in Your Portfolio – Follow-up from the Global Chinese Financial Forum Vancouver Conference

 

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