Yield curve inversion demystified: are we headed for a recession?

Any economist worth his/her salt is now talking about yield curve inversion and how it portends a recession. Here I try to explain the dismal science in lay terms starting with some basics. (Warning: I’m not a qualified economist!)

Bond yields:

Yield refers to the return on government bonds, and is the inverse of the bond price (a bond in high demand will have a high price and hence a low yield). In a period of high economic growth, investors can expect to make better returns from equities, so the demand for bonds will be relatively lower, and hence bond prices will be low and yields high. On the contrary, in periods of economic difficulty, investors tend to rush to safe havens like government bonds, increasing prices and lowering yields.

Short vs long term yields:

Usually you would expect longer term bonds to have higher yields than shorter term bonds - to compensate investors for risk (the longer the time horizon, the less predictable things are) and opportunity cost (you would expect equities to have better returns over a longer period of time). A plot of yields across various time horizons is called a yield curve.

Yield curve inversion:

The yield curve is said to be inverted when the yields on long-term bonds (typically 10-yr) are less than those on short-term bonds (typically 6-months to 2-yr). 

Inversion and recessions: 

A sustained inversion of the yield curve indicates that investors are fearful of the future and have lower returns expectations over an extended period of time. Hence, it is considered a lead indicator of an economic downturn. This phenomenon has preceded every recession in the US since 1950. Also, there was only one case in this period where an inversion was not followed by a recession (a false positive).

Current scenario:

The yield curve (10-yr v 2-yr) in the US is inverted, with investors fearful of the consequences of a prolonged trade war just as the longest expansionary phase in the US reaches a logical end. Most experts see this as an indicator of an impending recession, although there isn’t a consensus on the timing and magnitude. Also, in countries like Germany and Switzerland which are heavily dependent on global trade, the entire yield curve is in negative territory (which means people are paying the government to keep their money!), highlighting the pessimism of investors.

My recommendation:

Hope for the best, but prepare for the worst!