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What does an inverted yield curve mean?

We’ve all seen the doom and gloom headlines over the last week… $60 billion wiped off the ASX in a single day. The stock market’s worst day since February 2018. Fears of a recession spooks investors, sparking massive global sell-offs. The end is nigh.

And the reason for all this panic? The yield curve on the United States Treasury bonds inverted. Sounds pretty innocuous, doesn’t it? But this economic signal has been sending shivers down the spines of investors everywhere. A sea of red has spread from Wall Street all around the globe, and the ASX was not immune. Based on the way it’s been reported, you’d be forgiven for thinking the four horsemen had rode in and the Rapture was upon us. But what exactly does all this mean?

Untangling the yield curve

Put simply, the yield curve is basically just a graph of the interest rates that would be received on loans of various maturities. You plot your interest rates on your vertical axis, and your maturity durations on your horizontal axis.

When the economy is behaving normally and everything is relatively calm, the graph of the yield curve should slope more or less upwards. This is pretty intuitive, and an example of a term deposit you take out with a bank illustrates this point. Think of a term deposit as money you are lending to a bank – the longer the term deposit, the greater the interest you should receive.

This is for two reasons – firstly, the bank has to give you a greater level of compensation (in the form of interest) for holding onto your money for longer. This is because you might sooner be out spending that money on stuff you actually want, or generating a return from investing it elsewhere.

Secondly, the longer the time horizon, the greater your risk. You can have a rough guess at how things might pan out over the next few days or weeks (although given the current state of global politics that’s getting harder and harder). But extending that timeline out over months or years introduces more uncertainty. Maybe the bank you took out the term deposit with will go under and you won’t get your money back – that becomes more likely over a longer time horizon, and you need to be compensated for that increasing risk.

In summary: a shorter time horizon should mean less risk and a lower interest rate, whereas a longer time horizon spells greater risk and needs to be compensated by a higher interest rate. Graph a line between these points and you get an upwards sloping yield curve. Everything is rational and rosy.

But what happens if things are so out of whack that, for some reason, the interest rate on short-term loans is actually higher than the interest rate on longer-term loans? This would result in a curve that is downward sloping, or inverted. Which is where we are now – or where we briefly were when yields inverted last week. It’s also where we were just prior to the GFC.

What’s so bad about an inverted yield curve?

Well, think about the assumptions behind an upward sloping yield curve. The shape is really determined by risk – greater risk in the long term means a higher interest rate. So if the curve inverts, that means that the market is telling you short term risk is greater than long-term risk. Or, put another way, something bad is going to happen, and it’s going to happen soon.

And that bad thing is a recession.

That’s also the reason why those shares trading at inflated earnings multiples were the hardest hit. The valuations of growth stocks like Afterpay Touch Group Ltd (ASX: APT), Appen Ltd (ASX: APX), and even Bubs Australia Ltd (ASX: BUB) depend greatly on consensus expectations of their future earnings potential. If a recession is on the horizon, the probability that these companies will hit those lofty earnings targets starts to rapidly diminish.

Foolish takeaway

In times like these it often pays to hold your nerve. Sure, make efforts to de-risk your portfolio by investing in defensive stocks and bonds. But over the longer term, it’s often market contrarians that benefit the most from downturns. As Warren Buffett famously said, “be fearful when others are greedy and greedy when others are fearful.”

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Motley Fool contributor Rhys Brock owns shares of AFTERPAY T FPO. The Motley Fool Australia owns shares of AFTERPAY T FPO and Appen Ltd. The Motley Fool Australia has recommended BUBS AUST FPO. 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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