An economic downturn could soon be on its way if a recent development relating to the yield curve — which plots the yield on bonds against their maturities and is one of the most reliable indicators of the economy’s future — is anything to go by.

The yield curve has flattened drastically recently as a result of the combination of reduced inflation expectations, which position the long end of the curve for bonds with maturities of 20 or more years, and rising interest levels set by central banks, which position the short end of the curve. Bond managers worry that it will it invert so that short-term interest rates exceed long rates. If that were to happen, the yield curve — which normally rises over time — would decline.

An inversion signals that a recession could be only several months away, says Tom Czitron, fixed-income chief at Sceptre Investment Counsel Ltd. in Toronto. He adds that an inversion would drive many investors to keep their money in short-term, precautionary bonds and out of the stock market.

“The possibility is there,” he says. “In Canada, with two-year government bonds yielding 3.7% to maturity and 30-year bonds yielding 4.2% to maturity, the premium for going out three decades is just 50 basis points. Spreads keep closing; it’s a movement in one direction.”

The yield curve in the U.S. is even flatter. Robert Marcus, president and chief investment officer of Toronto-based Majorica Asset Management Corp. , notes that with two-year U.S. Treasury paper yielding 4.37% and 10-year T-bonds yielding 4.46% to maturity, there is a difference in return of just nine bps. That’s not much return for going long and taking on a decade of risk.

More worrying are expected moves by the U.S. Federal Reserve Board. “One school of thought is that Ben Bernanke [the nominee designated to take over as Fed chairman after Alan Greenspan retires on Jan. 31] will increase rates two or three times,” Marcus says. “That would cause the yield curve to invert in the U.S. If price pressures in Canada raise their head, the Bank of Canada will raise rates further.”

But will central banks raise rates so far that they bring on recession? It is a matter of opinion. Says Carolyn Kwan, financial markets economist at Scotia Capital Inc. in Toronto: “Greenspan no longer regards the yield curve as a predictive device. In his view, foreign governments keep buying Treasury bonds as they pile up trade surpluses with the U.S., so a period of short rates higher than long rates would not be that serious.”

Canadian investors cannot dismiss an inversion so lightly. Loonie bonds are not hoarded by foreign central banks and, one might argue, should not be when U.S. yields are significantly higher. And, as Anthony Crescenzi, chief bond market strategist with Miller Tabak & Co. in New York, explains: “The probability of recession increases with the yield curve’s inversion.”

Although a yield curve inversion may be a sign of bad times to come, it is also a signal to advisors and bond investors to adjust their strategies. Once a recession develops, central banks lower interest rates and bond prices rise, with mid- to long-term bonds rising the most.

“You want to anticipate that central banks will change their minds,” Marcus says. “When that happens, you want to be in the middle of the yield curve, where it tends to be steepest and has the greatest pickup in yield. That means you want something like a seven-year strip, which gets the most return for the period. It has the highest duration [responsiveness to interest rate changes]. The full gain on a strip is priced into the discount.”

However, Marcus warns, there is also a wrong way to play the inversion: “If the economy tanks, corporate yield spreads will widen. But this is no time to buy. Right now, yield spreads on corporate bonds over government bonds are tight. As the economy gets worse, corporate earnings suffer and the spreads widen. So you want to buy when spreads are wide. For now, it is better to stick with government bonds that have no credit risk.”

An alternative strategy is to go long with a 20- or 30-year bond and just wait out the correction when interest rates begin to fall, says Chris Kresic, senior vice president at Mackenzie Financial Corp. in Toronto. That would produce a large gain from declining interest rates, he explains.

@page_break@Timing is also of vital importance in playing the inversion. “The inversion will happen within the next six months if the market perceives the Fed going to 5% from 4% now, beyond the market expectation of 4.5%,” says Kresic. “If the Fed tightens more aggressively than expected, then there would be an inversion. If the Bank of Canada picks up the pace of tightening and the market is surprised, then we could get an inversion here [in Canada], too.”

An inversion would not last more than three to six months, Kresic adds: “Then the yield curve would normalize and steepen. So if you want to play the inversion, you have to be nimble and move before the window closes.” IE