Should you care about the yield curve inversion?

US stock markets experienced one of their worst days so far this year on Wednesday. The S&P 500 declined 2.93% after disappointing data from China and Germany increased the odds of a global slowdown. However, it was the warning signals from the bond markets that led to the steep selloff.

If you have been reading through recent financial headlines, the yield curve inversion topic seems to be the top concern for global financial markets. An inverted yield curve occurs when short-term bonds pay more than longer-term bonds. In other words, it’s when long-term interest rates fall below the shorter-term ones.

A part of the yield curve has been fully inverted since May, when the 10-year bond yields fell below the 3-month Treasury bill. Markets haven’t taken this inversion seriously as they pointed out to distortions due to global monetary policy, quantitative easing programs and negative interest rates, which were all factors that led to this inversion. But when the 10-year yields fell below the two-year notes yesterday, markets began to panic. The countdown to a recession has just started.

The yield curve has inverted before each recession in the past half-decade. Usually, a recession is hit 12 to 18 months after inversion occurs, and each one has slightly different circumstances.

What’s interesting about this one is that long-term interest rates are falling at a rapid pace. The 30-year bond yields have fallen 24% in just 14 days, and for the first time ever they trade below 2%. That’s despite the fact that the Fed has stopped tightening monetary policy and has begun reducing rates, which was supposed to have the opposite effect on long-term interest rates.

While investors may still make an annual return of 1.98% for holding 30-year bonds until maturity, when taking inflation into consideration they may end up with negative real returns. That’s a terrible situation for pension funds and some insurance companies who are obliged to have exposure to long duration bonds.

Given that it’s the first time we experience a yield curve inversion at such low interest rates it’s difficult to know the consequences on the global economy, but it certainly looks very alarming. Even the New York Fed puts the odds of a US recession at more than 30% in the next 12 months according to its recession probability indicator.

Historically, stocks continue to trend higher after the yield curve inverts, but given the different circumstances this time, investors need to be cautious. One sector investors tend to avoid is banks. Banks borrow at short-term from depositors and lend for the longer-term. When the yield curve is inverted, they struggle to make profit, and hence have less incentives to lend which eventually tighten credit markets.

No one knows when a bear market begins, but if the US and China don’t reach a trade agreement soon, the chance of one is highly likely. Increasing cash and gold holdings sounds like a good strategy at this point.