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Science versus history on predictive ability of yield curve

Recession may be imminent, but timing of selldown remains uncertainty
Investing 101

“Whatever you are thinking might be the trigger of a potential correction today, you are quite likely to be wrong” explains Michael Hampden-Turner, Director of Fixed Income at FTSE Russell in a recent blog post discussing the recession predicting capabilities of the yield curve.

Headlines have been dominated by the undeniable fact and historic analysis that showed an inversion of the 2-to-10-year US Treasury yield curve has been a ‘cast-iron harbinger of recession’ yet the truth maybe somewhere between the facts of what has occurred in the past, and the science that belies them.

The evidence is incredibly strong with the post highlighted that spreads went negative in 1998 before the Russian default, before the 2000s telecoms bust, in March 2006 before the GFC and even in 2019 before COVID-19 hit. “How could treasury spreads know anything about epidemiology,” asked Hampden-Turner?

  • There are a few reasons for this, which tend to come down to the unique conditions which exist at the time of aggressive rate hikes occurring or alternatively, forcing investors to the safety of 10-year Treasuries.  “Raising rates is like desperately throwing buckets of water on an ‘irrational exuberance’ fire hoping to dampen it down and avoid the bust. Once the fire becomes obvious, investors tend to relocate equity and other risk investments to 10-year treasuries for safety (some do notice early), this compresses the long end further flattening the curve”.

    Interestingly, whilst the yield curve has tended to invert before a recession, to timing from said inversion to the selloff in equity markets is incredibly varied. It has ranged from two months to 21 months and resulted in losses from 21 to 55 per cent of the equity markets value.

    “Considering their (central banks) delayed reaction, I reckon that this should give us a rough average of six to twelve months before an equity correction: that means the end of 2022/start of 2023 should be hairy”. However, with the final equity run before a recession-driven selloff normally ‘super profitable’ investors need to go beyond “keeping an eye on things” if they want to keep up.

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