This is part 1 of a 2-part series where we explain what exactly is meant by the term 'inverted yield curve' and explain possible ways to recession-proof your portfolio.

2020 has been one hell of a year and it has proven to us, yet again, that we can never fully predict the market. However, in March of 2019, the U.S. bond yield curve inverted briefly, predicting a recession, and one year later and a recession graced us with its pervasive presence. 

Now, this probably raised more questions than it answered, therefore this article will aim to take you through the basics of what a yield curve is, when it becomes inverted, and why an inverted yield curve is believed to predict a looming recession? 

Yield curves

A yield curve is a line that plots the yields of bonds that have the same level of risk (credit quality) but different maturity dates. The longer the maturity date, the higher the yield should be, whilst shorter maturity dates should see a lower yield. The primary yield curve that most investors tend to watch is the U.S. treasury yield curve.

An inverted yield curve (IYC) means that short-term debt instruments such as bonds are yielding higher percentages than long-term ones. Quite often this is taken as a sign of an unstable economy because it means that investors are switching their focus from the stock market, which is too volatile, to bond-buying, which is seen as a stable yet low return investment.

Bonds baby! 

To understand what a yield curve is, we need to understand how bonds work. Bonds are a type of tradable asset that is sold to investors who then receive interest payments on them until they expire (also known as 'maturity'). They are a form of debt allowing companies (or governments) to raise extra cash without taking out a loan. Bondholders will find that the price of a bond will fluctuate in response to the economy, whilst the guaranteed annual payout will stay the same, meaning it is a stable form of income for investors. 

Recession yay, or recession nay?

Historically, U.S. recessions are preceded by inverted yield curves, leading them to become an indicator of an impending dip. The Dotcom Bubble was thought to have been influenced by an inverted yield curve in 1998 (although this is debated), causing the Fed to cut interest rates creating the bubble of high growth; the Great Recession of 2007 was preceded by an IYC that lasted a week, leading to one of the worst recessions experienced in this lifetime; 2019 saw a brief one before 2020 tipped over into a recession. However, in this case, it was an event-driven market sell-off due to COVID-19 that caused the recession, whilst in 2007 it was a case of systemic failure. 

There is much debate surrounding the question: 

Does an inverted yield curve always predict a recession? 

The answer is not as simple as yes or no. For instance, the hype of an IYC might even itself cause a recession as many investors, who were riding out the volatility on the stock market, begin to pull out of their many investments. These spooked investors might instead be the cause of what they fear most, one might call this a self-fulfilling prophecy. 

Yet, as the last year has proven, other factors could contribute to a recession, such as a global pandemic. The Fed can modify interest rates but a recession can occur either way  -- typically within a 24-month window after the inversion. There has been only one example of a 'false positive' (unless you count 1998) and this was back in 1965. There is no definitive answer as to whether or not IYCs predict recessions, but they certainly can't predict a global pandemic, which begs the question:  perhaps 2019 was also a false positive? 

Essentially: all recessions are preceded by an inverted yield curve, and mostly all inverted yield curves mean that a recession is on its way. For our top tips on how to recession-proof your portfolio, part 2 can be found here. 

You can read part 2 of this 2-part series on How To Recession-Proof Your Portfolio here.

A MyWallSt subscription gives you access to over 100 market-beating stock picks and the research to back them up. Our analyst team post daily insights, subscriber-only podcasts and the headlines that move the market. Get your free access now!

MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in companies mentioned above. Read our full disclosure policy here.