Yield inversion does not a bear market make.
The media have had a field-day crying 'recession' as the United States ten-year interest rates fell below the short-term 3-month interest rates for the first time since 2007.
Always the drama queen, the noise coming from broadcasters has been intense in predicting a recession and if I was a nervous investor I would be sure to start worrying whether my hard-earned money was safe. Even more seriously, should I withdraw my funds now and save myself from certain losses just around the corner?
Perhaps I should hold off investing that money I had earmarked for investment until the yield curve has gone back to normal?
Well, one of our investment managers, Dimensional Fund Advisors, looked at the research to see what inverted interest rate curves actually meant for share market investors a year or two after the event. Their research was published in October 2018.
The point to notice here is that we are talking about the impact, if any, on share market returns, not whether there is a technical recession. By the way, a technical recession occurs when there are two consecutive quarters (3-month periods) where the economy has shrunk.
Marlena Lee, co-head of research at Dimensional, was quoted in a Bloomberg article that when they expanded their investigation to include five developed countries including the United States they found "about 70% of yield inversions were followed by positive share market returns which was much better than tossing a coin."
Dimensional found share markets had positive returns in 86% of the time one year after the event and 71% of the time three years after the event in those five countries over a 40-year period.
Why then are commentators transfixed with the current yield inversion in the United States?
The story goes like this. If an investor is prepared to lend their money long term, like 10 years, for a lower return than for 3-months why didn't they just buy the shorter-dated bond? They must expect that short-term interest rates are going to fall even more and over the longer term they will be better off taking the lower interest rate and locking it in for longer.
So, an inverted yield curve is a bet by the collective wisdom of the bond market that short-term interest rates are going lower which is another way of saying that the economy is so sick that it will need stimulating by the Reserve Bank who will have to continue lowering interest rates.
Might the bond market be right? Of course it could. It is one possibility for the future, but still only one. Why try and double guess it? There are a huge number of things that can change the outlook at the blink of an eye. And share markets are not the economy. There are other forces at play there such as supply and demand as well as the unknown future behaviour of consumers, businesses and governments that will all have an impact on the future of share prices.
We can get caught up in a story about falling interest rates or we can trust that nobody knows what will happen this time or any other time. We are all patient onlookers of history unfolding before our eyes. Beware the charlatan who reckons they know what is about to happen next. History will show, on average, they would be better off riding through the ups and downs of the market.
Keep asking great questions ...