Bonds may seem less exciting than stocks and real estate, but many think that they’ve got one unmatched superpower: the ability to predict economic recessions.
As fixed income securities, bonds pay a set amount of interest periodically based on their coupon rate until they reach maturity. But bonds can also be traded on a secondary market and experience the same price volatility as stocks; these are known as “exchange-traded bonds”. An ETB’s return is determined by the bond yield, which is its annual interest payment divided by its market value.
Since World War II, the bond market’s yield curve has accurately flashed warning signals of incoming economic recessions. As a graphical representation of bond yields across different maturities – from short-term bonds to long-term bonds – the yield curve normally slopes upward. It makes sense for short-term bonds to have lower yields than long-term bonds after all – you expect higher returns for a longer-term investment.
But abnormal circumstances can cause the yield curve to invert. That’s right, the graph becomes downward-sloping, meaning that short-term bonds have higher yields than long-term bonds. This happens when investors become pessimistic about economic prospects in the near future and move away from short-term bonds to pile into long-term bonds. The latter’s market value increases, leading to lower yields when calculated as above.
It may sound extremely simple, but a yield-curve inversion has preceded the last seven recessions, including the burst of the Dotcom Bubble and the GFC. And based on this history, the recession usually comes about 15 months after a yield curve inverts.
Interested in what the yield curve looks like right now? Well, it’s inverted. But while its predictions have been accurate so far, it’s also the first time in history that it’s succeeding a global pandemic. Investors, at the very least, seem to be largely optimistic about the market’s outlook. Let’s see whether the yield curve's predictive streak continues or if we finally get to say the indicator raised a false alarm.
Stella is a markets analyst and writer with almost a decade of investing experience. With a Masters in Accounting from the University of Sydney, she specialises in financial statement analysis and financial modelling. Previously, she worked as an equity analyst at Australian finance start-up, Simply Wall St, where she took charge of the market insights newsletter sent out to over a million subscribers. At Stake, Stella has been key to producing the weekly Wrap articles and social media content.