What the curve measures
The yield curve plots the yield on government debt against its maturity. In ordinary conditions it slopes upward: lenders demand more to lock up money for ten years than for two. The slope reflects a combination of expected future short-term rates and a premium for bearing the uncertainty of a longer horizon.
When the curve flattens, the market is pricing in lower future short-term rates relative to today, or a smaller premium for duration, or both. When it inverts, with short-term yields above long-term yields, the market is pricing in a meaningful decline in future short-term rates, which historically has coincided with periods of slowing growth.
Sector behaviour across curve regimes
Different equity sectors have historically responded differently to the shape of the curve. Banks, which borrow short and lend long, tend to see margins compress when the curve flattens. Utilities and other sectors with bond-like cash flows tend to be more sensitive to the level of long-term yields than to the slope. Sectors whose earnings are tied to the economic cycle have tended to underperform in the period following an inversion, as the slowing growth the curve anticipates arrives.
These are historical tendencies with considerable variation around them, not rules. Their value is in providing a framework for asking whether a portfolio's sector exposure is consistent with the conditions the curve is pricing, or is implicitly betting against them.
The lag problem
The curve's reputation as a recession indicator rests on the observation that inversions have preceded most post-war recessions in the United States. What is less often noted is the variability of the lag, which has ranged from several months to more than two years, and the fact that equities have on several occasions continued to rise for an extended period after the inversion.
An indicator with a lead time that varies by a factor of four is not a timing instrument. Treating it as one has historically led to being positioned defensively for long periods during which the anticipated slowdown had not yet arrived. The curve is more usefully treated as a description of the market's rate expectations than as a signal to act.
Using the curve as one input among several
A disciplined approach records the slope of the curve at regular intervals alongside other measures of the cycle: credit spreads, leading indicators, and the direction of earnings revisions. When several point in the same direction, the case for adjusting sector exposure is stronger. When the curve is alone in signalling caution, the appropriate response is usually to note it and wait for confirmation.
The curve is a valuable piece of context. Its misuse comes from asking it to do more than describe what the bond market currently expects.
Key points
What to take from this note
- 01The curve reflects expected future short-term rates plus a premium for duration.
- 02Sectors have historically responded differently to curve shape, but the tendencies vary considerably.
- 03The lag between inversion and slowdown has varied by a factor of four, making it a poor timing tool.
- 04The curve is best used as one input among several, and as a description rather than a signal.
Goat Academy is an online financial education institution founded by economist and former investment banker Felix Prehn.
This article is general market commentary published for educational purposes. It is not financial, investment, or tax advice, is not a recommendation to buy or sell any security, and should not be relied upon as a basis for any investment decision. Trading and investing carry risk, including the loss of capital.