What is a Yield Curve?
A yield curve is a graphical presentation of the term structure of interest rates with the bond yield on the Y-axis and the years to maturity on the X-axis. To construct a yield curve we need to look at bonds only from a homogenous group, the same risk class with the same degree of liquidity.
Yield Curves (Source: XPlaind)
For a normal yield curve long-term yields are typically higher than the short-term yields because of the higher risk in the long-term investment. An inverted yield curve is just the opposite. The yield on the short-term bonds is higher than the long-term bonds. An inverted yield curve has traditionally been associated with economic recession. Investors expect the longer-maturity bond yields to go even lower in the future, and try to purchase long-term bonds before the yield goes lower. The increasing demand for long-term bonds lead to higher bond prices and lower yields.
Yield Curve is Yet to Invert (Truly)
The yield curve of US Treasuries, as it stands on June 17, 2019, shows that only the front-end of the curve is inverted.
Current Yield Curve (Source: Marketwatch)
At the end of May the spread between the yields on 3-month and 10-year Treasuries turned negative, while the spread between the yields on 2-year and 10-year Treasuries did not. We think, the latter is more significant than the former, since the short-term yields are heavily influenced by central banks such as US Federal Reserve, BOE etc. and the long-term yields truly reflect the expected short-term interest rates in future and the market expectation of the inherent risk.
Currently the spread between the yields on 2-year and 10-year Treasuries is almost near its lowest levels since the financial crisis and the last US recession in 2008-2009. In all past recessions this spread had often gone into inversion in the period leading up to the recession, and that has not happened yet.
Risk of Opportunity Loss
An inverted yield curve in the 2-year to 10-year Treasury spread has always been a precursor to every US recession since sixties. However, not every yield curve inversion has been followed by a recession. Also note that the stock market normally peaks between an inversion and a recession, and there is a price to pay by bailing out of the stock market too early.
The Treasury yield curve inversion is not a guarantee of an imminent recession. In the current market backdrop the drop in the 10-year yield has been caused more by equity jitters induced by the trade war, global economic slowdown and safe haven flows into USD-denominated less risky bonds.
At QuanTimer we follow our own trend timing system based on an advanced statistical model which we believe is a much better prognosticator of the market downturn. We will, therefore, continue to trade based on our signals with stop loss and trailing stop loss orders that will provide just the adequate safety net that we need.
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