Where is the Yield Curve Pointing?

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Take a look at this chart:

Yield Curve

Source: Bloomberg


It’s the Australian yield curve. That may not mean much to you. We’ll explain what it is below. But what you need to know right now is that this chart is even scarier than the ASX200 chart. Which is scary too:

S&P/ASX 200 Index Chart

Source: ADVN


Why is the yield curve more of a worry than seeing stocks plunge? Because yield curves in the shape of a tick, like the Australian one is now, often predict recessions. Back in 2007, the US yield curve looked similar to the Australian one now. If you had heeded its warning then, you could have avoided the subsequent 50% plunge in stocks as the American economy tanked.

So what is the yield curve?

It’s easiest to explain with an example of how to construct one. But first you have to understand how bond yields work. A bond’s yield is its % return on an annualised basis. Because bonds are a promise to pay a fixed amount of cash in the future, a higher price indicates a smaller return. If a bond promises to pay $100 at the end of the year, a $91 price gives you a 10% yield, while a $95 price gives you a smaller 5% yield. It is a convention to quote bonds by quoting their yields rather than their prices, as this makes them easily comparable across different maturities. (Maturities are when bonds expire. Common maturities include 3 and 6 months – and 1, 2, 10 and 30 years.)

You can draw a yield curve by plotting the yields of bonds with different maturities and joining them with a line. So if a 1-year bond yields 3.8%, a 2-year bond 3.5%, a 10-year bond 4.15% – and so on – you get the following yield curve:

yield curve

According to one theory, yield curves predict what interest rates will be in the future. Based on the curve above, which is the Australian one, the bond market expects interest rates to fall for two years and then rise. This is consistent with what you might read in the newspapers, which claim that the RBA’s next interest rate change will be down. Economists use the yield curve to make that prediction.

But why do expected changes in the interest rate predict a recession? Because interest rates tend to move with the economy. As it weakens, interest rates go down. The question is, how low? But that’s a question for other indicators.

Here is the key point about the yield curve. The Australian yield curve is the only honest one left around the world. Because of intervention by central banks into bond markets in Switzerland, the US, UK and Europe, the yield curves of nations in those monetary regions are no longer ‘honest’. When central banks create money, they inject it into the economy by buying the very bonds that make up the yield curve. This changes the shape of the yield curve, which reduces its predictive power.

But the Aussie yield curve, relatively unmanipulated, continues to point downwards. Is this a hint that if central bankers hadn’t manipulated other nations’ yield curves, they would point down too? That would imply recessions in those countries. That’s because they are already growing so slowly any change for the worse would put them into recession.

But could the yield curve be warning you of Australia’s coming recession too?

It makes sense to us.

And if you think so, it might be time to readjust your portfolio. Even your entire strategy. With the market back to 2004 levels, perhaps it’s time to try something new?

Dan Denning reckons he has an idea for his Australian Wealth Gameplan subscribers. And it’s one that works to preserve your wealth generally, not just provide returns. If ever there was a time to preserve wealth, this is it.

You can find out more about his strategy here.

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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2 Comments on "Where is the Yield Curve Pointing?"

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Patrick Donnelly
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Very good and timely article. Simple test too.

I don’t find the falling rates a problem. The possible increases in interest scare me!! That will of course, flatten out as time goes by and the world wide depression takes hold!

This only relates to the financial economy…… the real one, in Australia will be quite good! So, do not despair! We are the Lucky Country!

gorghast
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A ‘walking stick’ yield curve is a long known signal to impending disaster in the debt market. The vast debt market’s tectonic plate grinds away as a fault line, against that of the equally, obdurate equity market’s tectonic plate. In consequence when the yield curve arches trouble and disaster is boldly foretold. It is perhaps the only reliable seismic economic gauge. So pointing to an impending earthquake! (This in terms of this stretched metaphor.) Yet I believe —> “According to one theory, yield curves predict what interest rates will be in the future. Based on the curve above, which is… Read more »
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