Most people have a simple and basic understanding of what a yield curve inversion means. They know that it is unusual and every headline tells them that its bad news for the economy. Some are even aware that when a yield curve inverts, long-term interest rates fall below short-term interest rates as investors require greater return for locking up their funds for 2 vs. 10 years. Yield curve inversions in the US and UK triggered a wave of panic in the financial markets today. The Dow Jones Industrial Average dropped more than 700 points, money flocked into safe haven currencies, gold prices increased and oil prices fell sharply. All of these moves are consistent with risk aversion.

Investors are anxious because yield curve inversions accurately predicted each of the last 7 recessions including the Great Recession. But it is important to understand that while recessions are always preceded by yield curve inversions, inversions do not always lead to recessions. There are plenty of false positives and according to a Credit Suisse study, it could be 22 months before a recession follows. Also, many officials from the Fed have expressed their skepticism about the importance of the shape of the yield curve. They believe other factors influence the curve's shape besides the future strength of the economy like the low level of term premiums that can be affected by central bank buying. Central bank activity could undermine the accuracy of the yield curve as an indicator of economic activity. This is also the first yield curve inversion since 2007-2008 and when premiums are low, inversions can become more frequent without an increased risk of recession.

With that said, you should be worried. It would be easy to dismiss the signal from the yield curve if the global economy is doing well and brighter times lie ahead but that's not the case. Well before the yield curve inverted, central bankers across the global have been talking about weaker growth. Many resorted to easing monetary policy to boost inflation and activity and more accommodation is expected in the next few months from major central banks like the Fed and ECB. Between the intensifying US-China trade war, Brexit, protests in HK and political trouble in Italy, portfolio managers and investors have a lot to worry about. Any one of these issues could tip one if not many countries into recession. So regardless of the durability of the yield curve inversion, the risk of recession this cycle is greater than its ever been.

For consumers, borrowing rates will fall but stock market losses could accelerate.For investors, more money will rotate from stocks to bonds, leading to a broader decline in the Dow and S&P. For currency traders, the pairs that are the most sensitive to risk appetite like USD/JPY and NZD/JPY will be hurt and the ultimate winners will continue to be the funding currencies - the Japanese Yen, Swiss Franc and to some degree, also the euro.

As we said at the start of the week, nothing matters more than risk appetite and news bombs. EUR/USD broke down despite slightly better EZ GDP data while GBP/USD was flat despite stronger inflation. Tonight, Australian labor market data is scheduled for release and will only have a meaningful and lasting impact on the Australian dollar if it is weak, reinforcing current market sentiment. UK and US retail sales numbers are also on the calendar and while wage growth accelerated in July, retail sales alone won't affect the market's expectations for Fed easing and recession.

Past performance is not indicative of future results. Trading forex carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to trade any such leveraged products you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with trading on margin, and seek advice from an independent financial advisor if you have any doubts.

Analysis feed

FXStreet Trading Signals now available!

Access to real-time signals, community and guidance now!

Latest Analysis


Latest Forex Analysis

Editors’ Picks

EUR/USD falls below 1.1850 as US consumer sentiment beats

EUR/USD is trading under1.1850, off the previous levels as US consumer sentiment beat estimates with 78.9 points. The Fed refrained from adding more stimulus, supporting the dollar earlier in the week. Investors are eyeing fiscal stimulus talks.

EUR/USD News

GBP/USD falls as the EU reportedly objects Johnson's bill

GBP/USD is trading around 1.2950, off the highs. According to reports, the EU remains opposed to UK PM Johnson's controversial bill, which violates the Brexit accord. 

GBP/USD News

XAU/USD struggles to move back above 100-hour SMA

Gold regained some positive traction on the last trading day of the week and recovered a part of the previous day's losses to over one-week lows. The commodity held on to its intraday gains and traded above the $1950 level through the mid-European session.

Gold News

Ethereum hits Bitcoin's bid to lead the market

Bitcoin risks dominance after the strong rise of Ethereum. Technical indicators show some significant discrepancies keeping the stress on the board. Sentiment levels are improving and bordering on optimism.

Read more

After yesterday's JMMC meeting WTI settles near $40 per barrel

WTI has been through a rollercoaster this week. The liquid gold has been in a downtrend leading into the OPEC+ JMMC meeting and then reversed the whole move. At the meeting the group agreed to extend the compensation period for overproduction till the end of December. 

Oil News

Forex Majors

Cryptocurrencies

Signatures