The yield curve has flipped upside down. What does this mean?
Before we dive in, let us reassure you that we will walk you through this concept step by step đ Donât be scared off by jargon or big finance words.
First thing’s first; letâs bring you up to speed on what a yield curve is. A yield curve indicates the expected interest rate levels in an economy over a time. A yield curve illustrates the expected interest rates at different points in time in the future, the shape the line makes is often defined as a curve.
Since the Global Financial Crisis (GFC), there have been long multi-year periods where the short-term interest rates in major economies, like the Reserve Bank of Australia (RBA) cash rate, have been at or near zero, and at higher expected interest rates in the medium and long term, e.g. 5 to 10 years. This creates an upward sloping curve.
It slopes up because interest rates rise over time, meaning the expected interest rate at year 2 is lower than year 3, which is lower than year 5.
But for the first time in many years, the short-term interest rates that markets expect from Central Banks in both the US and Australia are moving higher, even higher than the medium and long-term expected interest rates.
In this case, itâs a comparison between the 2-year yield  and 10-year yield, and the the 10 year yield is lower than the 2 year yield â the curve is no longer sloping up and this phenomenon is described as the yield curve âinvertingâ in market jargon, or turning upside down.
But what might this mean for equity markets and investing?
Do higher interest rates in the short term imply a recession is coming?
Yield curve inverting for extended periods is seen as an indication that the economy may be heading into a recession. A recession is defined as two consecutive quarters of negative growth in an economy. Higher interest rates in the short-term do not necessarily mean a recession is coming, nor that one is coming immediately. But the effect of rising short-term rates can be a move over a period from higher risk investments to lower risk cash-like products offering a higher interest rate, like an interest rate at a bank. Over time, as money movement slows in an economy, it can lead to a period of lower or negative growth.
What could higher short-term interest rates mean for markets?
While some market observers expect the inverted yield curve to be an indicator of a potential recession, the previous four times the 2-year and 10-year yield curve inverted in the US, the S&P 500 Index ended up rallying for a further 17 months, gaining 29% before peaking*. This could be because there is a period where economies adjust to higher interest rates, and that the movement of assets is gradual.
*Source: AFR Article 3rd April 2022, US wages spike triggers 10 rate rises, inverted yield curve
Equity markets and monetary policy are not the same
Itâs worth noting that just as interest rates can move up and down, so can markets. It is not always clear what happens to equities as interest rates tick up, and it has been many years since this was last seen in global economies, but the data suggests that higher short-term interest rate expectations does not immediately take all of the potential upside out of the equity markets.
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