Inverted yield curves

Ask the average retail punter about the significance of an inverted bond yield curve and you’re likely to get a blank look. However this is potentially the most important issue facing investors right now, whether they know it or not.

The bond market is the single most influential segment of the financial markets. It sways all aspects of your investment portfolio because bonds are often the starting point from which other assets are valued. So the current situation where longer-dated bonds are yielding less than cash is worth keeping an eye on as it is likely to put a strain on asset prices in the future. In effect, long- and short-term bond yields are out of kilter, presenting all sorts of problems in weighting asset portfolios, and possibly presaging a recession or at the very least some stock market volatility around the corner.

So what does this slightly esoteric part of the economic landscape mean for investment decision makers?

A normal yield curve (with a positive gradient) reflects the fact that investors get paid more for locking their money away for longer periods. The yield curve is also an implicit forecast of future interest rates, and by extension, a forecast of inflation expectations and economic activity. As such, a gently upward curve implies modest inflation and gently rising rates consistent with a strong economy.

An inverted (downward sloping) bond yield curve represents a view among investors that interest rates in the future will have to be lower than they are today, most probably due to slowing economic growth.  Bond market participants have a fairly strong track record in predicting a slowdown in economic activity globally. Another potential reason for an inverted yield curve - why long-term yields might be lower than short-term yields - is excess demand, whether from global pension funds or countries sporting a trade surplus. The excess demand argument appears plausible, particularly while a recession does not appear to be on the horizon. However, investors cannot afford to be complacent as, at some point, fundamentals will reassert themselves.

There is little upside to an inverted yield curve. Stronger risk aversion would suggest a bias toward shorter duration or relatively inflation-proof investments. A more long-term outlook suggests an absolute-return orientation. Also, if peer group risk is a preoccupation, then large bets relative to the strategic benchmark should be avoided until a more normal yield curve is observed.

Simon Ibbetson is head of Investment Consulting at Standard & Poor’s

Reproduced with permission from financial alert.

© 2006 financialalert, Brillient Investment Publishing Pty Ltd ABN 19 122 531 337.

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