Insights

The yield curve as a leading indicator

By Paul Reid

20 February 2024

yield curve as a leading indicator

If you have financial news running in the background all day, you’ve probably heard analysts talking about the yield curve. Let’s explore the yield curve as a leading indicator and see if it can help traders forecast the US economy and consequently US assets such as stocks and USD.

What is a yield curve?

The yield curve is a graph that plots the yields (interest rates) of bonds with differing maturity dates, typically US Treasuries. Under normal circumstances, this curve slopes upward, reflecting higher yields for bonds with longer maturities. This is based on the premise that investors require more compensation (higher yield) for tying up their money for an extended period, given the greater uncertainty and inflation risk.

Here’s how a healthy yield curve should look.

What is a yield curve inversion?

An inversion of the yield curve occurs when certain short-term interest rates exceed the long-term, causing the rising curve to suddenly slope downwards. This inversion is not just a statistical anomaly; it reflects broader economic sentiments.

Here’s a yield curve chart as of 12 February 2024:

As you can see, at the time of writing, there is a yield curve inversion. An inverted yield curve indicates that investors foresee a weakening economy ahead and thus opt for the safety of long-term Treasury bonds, which pushes long-term yields below short-term.

Such a negative sentiment is capable of causing a domino effect that leads to recession, but it’s not a direct mechanism. Simply, Consider a yield curve inversion as you would any other indicator. It suggests an outcome but doesn’t guarantee it.

What traders might watch out for in 2024

In addition to the yield curve, pay attention to updates from the Federal Reserve Bank of New York's recession probability tool. A rising probability figure may warrant a review of your trading strategy.

Keep an eye on other economic indicators such as GDP growth rates, unemployment figures, and consumer confidence indexes. No single indicator can provide a complete picture, but together, they offer valuable insights.

Conclusion

At the time of writing, the yield curve is inverted. Equity markets may react negatively to an inverted yield curve, as it is traditionally seen as a predictor of economic downturns. Investors may become more risk-averse, leading to sell-offs in riskier assets like stocks, particularly those in sectors more sensitive to economic cycles (e.g., finance, real estate, consumer discretionary).

Gold and other precious metals often perform well during times of economic uncertainty as investors look for safe-haven assets. An inverted yield curve may drive increased demand for these assets, potentially pushing their prices higher.

The US dollar could either strengthen or weaken against other currencies, depending on investors' perceptions of the US economy relative to other economies. A strong move into Treasuries from foreign investors seeking safety might bolster the dollar, while domestic concerns about recession could weaken it. Commodities like oil may see price declines if an inverted yield curve signals an economic slowdown, as reduced economic activity can lead to lower demand for energy and industrial metals.

Keep notes in your trading journal and aggregate the results of your research. If the numbers are united in forecasting a particular trend for your preferred asset, you can perhaps trade with higher confidence. Otherwise, consider alternative assets outside of the USD ecosystem.

The most prudent course of action, underscored by decades of market history, is to remain steadfast in your trading strategies. By staying invested, you can not only navigate through temporary downturns but also position yourself to capitalize on the inevitable rebounds, turning challenges into opportunities for growth and prosperity.

In the end, the journey of trading is not about evading storms but learning to sail in all conditions, with an eye on the horizon. The future may hold uncertainties, but armed with knowledge, patience, and a long-term perspective, we can chart a course through turbulent waters toward a prosperous destination.


This is not investment advice. Past performance is not an indication of future results. Your capital is at risk, please trade responsibly.


Author:

Paul Reid
Paul Reid

Paul Reid is a financial journalist dedicated to uncovering hidden fundamental connections that can give traders an advantage. Focusing primarily on the stock market, Paul's instincts for identifying major company shifts is well established from following the financial markets for over a decade.