The mystery of the inverted yield curve

For anyone working in the financial markets, the inverted bond yield curve is a terrifying concept. For most, the fear comes simply from having to grapple with this odd-sounding but oft-repeated phrase. For those in the know, it claims to foretell doom and gloom.

For both groups, 2007 has got off to an unhappy start. When the yield on a long-dated government bond, such as the 10-year US Treasury, falls below that of its shorter-term sisters, such as the two-year, that is known as an inverted curve. Currently the difference is just 10 basis points (0.1 percentage point): 4.78% versus 4.88%.

This is unusual because a bond that matures in 10 years’ time should be a riskier bet than one which matures sooner as inflation can spike at any time over a decade. So investors normally demand a premium – a higher rent for taking out a greater risk – and a graph plotting yields against maturities (a yield curve) should show the latter rising as the former lengthen.

When the yield is lower long-term, it implies investors are rushing to buy long-dated bonds because they believe there is something nasty around the corner that will pull down inflation: a slowdown or recession.

Billions of pounds are invested in long-dated bonds so buying into low-yield, high-priced bonds carries a potentially expensive risk of a sudden snap-back if the outlook changes.

The American market, the largest and most complex, has had an inverted yield curve for more than a year. When it inverted just before New Year’s Eve 2005 it prompted a furious debate over its efficacy in forecasting recession. That debate is still under way a little over 12 months on.

Supporters of the standard view, such as Andre de Silva, a senior fixed-income strategist at HSBC, point out that the yield curve has correctly predicted recessions in 1973-1975, 1980, 1981-1982, 1990-1991 and most recently the mild downturn of 2001.

He sees the curve as supporting HSBC’s view that the US is headed for a slowdown to levels below the 2.3% average of forecasts logged by Consensus Economics.

Critics of the curve’s predictive merits point out that it is more than a year since inversion began and the US has posted growth above 3%. The latest figures point to an economy maintaining good speed in the face of a headwind from an ailing housing market.

Retail sales and recruitment are the latest in a litany of data pointing to an American economy heading for a soft, rather than a hard, landing. Meanwhile a substantial improvement in the budget deficit is likely to reduce supply of new short- and medium-dated issues. Little surprise short rates are rising.

So could there be any other explanations for the movement at the long-end? There are four factors that were less prevalent in previous economic cycles and which could point to a change in the fundamentals of supply and demand for long-dated paper.

The first is that major central banks can be credited for gaining the upper hand in the fight against inflation, at least when compared with the 1970s and 1980s. Investors can there-fore be more sanguine that the risk inflation will wipe out the value of their bond investments than they were in the previous three decades, even if British inflation is creeping up again (see Editorial, pages 8 and 9).

Second, China had led aggressive bond buying by Asian countries. These emerging economies have used their huge current account surpluses to build foreign currency reserves as insurance against a repeat of the 1997 East Asian currencies when they found their dollar debts became unbearable as their currencies collapsed. It has recently emerged that China had amassed $1 trillion of dollar assets (see Trusted Sources, p17).

A third and connected factor is the mass purchase of bonds by Opec countries keen to lock away their petrodollar windfall from record high oil prices as insurance against a collapse further out. Certainly yields on the 10-year Treasury points to more buyers than sellers.

Last, pension funds have either chosen – or, as in Britain, been compelled by regulators – to buy long-dated assets to match a shift in their liabilities created by the fact that people are living longer. Britain has an even more pronounced inversion than the United States, allowing the government to respond by issuing 50-year bonds. Demand was so strong it sold them for a real yield of 0.83%. Following last week’s surprise rate rise to 5.25% yields on the two-year gilt jumped to 5.35% while the 10-year was paying 4.85%.

Nick Stamenkovic, a seasoned bond analyst at RIA Capital Markets in Edinburgh, says there is less agreement now about the impact of the inverted yield curve. “Increasingly, the curve globally has been driven by the supply and demand picture,” he says.

Analysis by David Miles of Morgan Stanley shows low long-bond yields were the norm until the inflationary post-War period. Over the past 300 years, the average yield on long-term gilts has been close to the current level and in the 19th century were close to 3%.

In the United States, Ben Bernanke’s Federal Reserve has taken a dismissive stance of the relevance of the inverted yield curve, much as Alan Greenspan did under his reign.

So, who’s right – the Fed or the markets? The jury is still out but traders and analysts must beware. Investments tied up in global bond markets are huge and the consequences for financial markets being wrong-footed would be cataclysmic.

Inverted yield curves don’t last for ever, a lesson no investor should ever forget.