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Why an inverted yield curve has investors worried the S&P/ ASX200 could crash

The S&P/ ASX200 (ASX: XJO) is down 2.6% to 6,243 points this afternoon and is following the Dow Jones, S&P 500, and Nasdaq 100 lower on the back of rising concerns a global recession is around the corner. 

The selling is being attributed to the inversion of the U.S. debt yield curve overnight, where rates of interest paid on 10-year government bonds are now lower than the rates paid on 2-year government bonds.

As at 14.45pm AEST U.S. 2 year treasuries are at 1.557% and 10 years at 1.549%, with even 30-year treasury yields below 2%.

Economic textbooks teach that in a healthy economy yields on longer dated debt should be higher than shorted dated debt as there are greater unknown risks to an investors’ capital the longer into the future you go. 

As bond prices rise because of more investor demand for their relative safety, yields fall just as with equities or property for example.

The more demand for longer dated bonds and associated lower yields the more it suggests debt investors are panicked about where to park their money due to their view the global economy is weakening or about to tumble.

More generally the lower bond rates fall across different terms to maturity the more negative bond market investors are about global growth, as lower yields mean they’re willing to accept lower returns.

Of course an “inverted yield curve” is no guarantee a recession is coming and the yield curve may quickly revert to a marginal incline on news of a trade truce between the US and China for example. 

Partly in response to the ‘tariff war’ central banks globally are moving to cut interest rates in order to lower their currencies and protect export markets as global growth slows. The lower benchmark lending rates are also contributing to the lower short term debt rates such as US 2-year treasuries for example. 

While a recession (i.e. consecutive quarters of negative GDP growth) in the US, China or Australia would spell bad news for equity investors it’s important to remember that as risk free or benchmark debt lending rates tumble the earnings growth and dividends offered by quality equities will become more valuable. 

Therefore there’s no need to change an investment strategy of only buying high-quality companies on a regular basis. In fact if valuations get cheaper you’ll be able to buy more for less. Some companies I have my eye on include CSL Limited (ASX: CSL), Macquarie Group Ltd (ASX: MQG) or Xero Limited (ASX: XRO).

Another option popular with traders is to buy gold miners as the precious metal tends to appreciate in value in times of recession as it’s considered a ‘flight to safety’.

So if you’re gripped with an evangelical certainty that a crash is coming you could take a look at the likes of Northern Star Resources Ltd (ASX: NST), Newcrest Mining Limited (ASX: NCM), or St Barbara Ltd (ASX: SBM).

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Tom Richardson owns shares of CSL Ltd., Macquarie Group Limited, and Xero.

You can find Tom on Twitter @tommyr345

The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. The Motley Fool Australia owns shares of and has recommended Macquarie Group Limited. The Motley Fool Australia owns shares of Xero. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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