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global yield curve inversion

Not looking great: what the yield curve says about stocks

August 2018

Luca Paolini, Chief Strategist

An inverted yield curve is a bad omen for the economy and stock markets. 

Will the yield curve get it right once again?

With long-dated global bonds yielding less than short-term bills for the first time since 20061, investors may be hoping not. 

That's because an inverted (or flattening) yield curve has historically proved a reliable predictor of recessions and bear markets in stocks. In the US, for instance, each of the last seven slumps has been preceded by an inversion of the curve.

But while a sharp downturn doesn’t look imminent, investors shouldn’t wait too long before bolstering their defences.

To understand why, it’s useful to take a closer look at what an inverted yield curve actually shows.

In our view, the yield curve is essentially a proxy for a country's output gap - or the difference between an economy's current rate of growth and its long-term potential. Seen from this perspective, any flattening or inversion of the curve implies the economy is closer to hitting its speed limit, at which point it will quickly begin to decelerate.

Given how far yields on long term bonds have fallen relative to those on shorter maturity debt, our analysis indicates the global economy is entering the last phase of its expansion, one that began back in 2009.

This, in turn, means developed market equities are likely to deliver far more muted returns in future.

More specifically, our calculations show that with the yield gap between two and 10-year yields having narrowed to just 30 basis points, investors should expect a nominal yearly return of just 3 per cent per year from equities over the next five years. That's down from a return of 13 per cent annualised during the previous five. 

An inverted curve is a bad omen for the economy and equity markets. There's no reason to believe this time will be any different.

turning upside down

Yield spread between JP Morgan Global Bond Index 7-10 year and 1-3 year

yield curve

Source: JP Morgan, Bloomberg, Pictet Asset Management. Data covering period 31.07.1998 - 03.08.2018