The yield curve is a key tool used by financial analysts to forecast future economic and inflation conditions and to project future interest rate changes, as such understanding the yield curve is crucial to making informed investment decisions.
The Edge Singapore spoke to Winston Lim, head of deposits and wealth management at UOB, on understanding the different yield curve shapes and the distinct implications it has for various asset classes.
The yield curve represents the relationship between interest rates on bonds across different maturities, ranging from both short-term to long-term.
A normal yield curve is an upward-sloping curve which reflects higher yields for longer-term bonds compared to short-term bonds, indicating a healthy and growing economy that will lead to higher inflation and interest rates.
An inverted yield curve is a downward-sloping curve which occurs when short-term yields exceed long-term yields.
According to Lim, an inverted yield curve signals that investors expect future interest rates to be lower than current rates. This tends to be in response to an economic slowdown or concerns of a potential recession.
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Conversely, a flat yield curve indicates that yields across different maturities appear to be similar, often indicating uncertainty or a transition between economic cycles.
Lim notes the shape and movement of the yield curve can impact market sentiment, influencing an investor’s portfolio allocation.
Bonds
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Bonds prices and yields are inversely correlated. When yields rise, bond prices fall, and vice versa.
As such, investors may diversify their bond portfolio by allocating to different parts of the yield curve in response to the current interest rate environment.
Typically, a steeper curve will compel investors to invest in longer maturity bonds due to higher yields, while a flat or inverted curve may encourage investors to look at bonds with shorter maturity.
Stocks
Lim states that companies often rely on borrowing to finance growth.
Therefore, an upward-sloping yield curve typically means longer-term debt is more expensive than short-term ones, indicating that companies which rely on short-term debt will find it cheaper to borrow for business expansion needs.
Lim highlights that this is a normal yield curve, representing a growing economy, which may benefit cyclical sectors like industrial and consumer discretionary.
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Conversely, an inverted curve means that short-term debt is more expensive than longer-term ones, so it is theoretically cheaper for businesses to borrow for long-term investments such as machinery and plant upgrades.
Nonetheless, an inverted yield curve also signals a potential recession ahead, which may complicate the expansion plans for businesses. In this environment, defensive sectors like utilities and healthcare are likely to outperform.
Currencies
The shape of the yield curve reflects the future interest rate outlook for each country, and differences in the shape of the curve can influence foreign exchange rates.
Lim adds that currencies with comparatively higher bond yields may attract foreign investors, causing them to strengthen.
Ultimately, Lim encourages investors to include a balanced mix of assets, including stocks, bonds, units and exchange-traded funds (ETFs), within their investment portfolio.
According to Lim, multi-asset strategy unit trust funds and dividend-paying stocks offer growth and diversification, while investment-grade bonds and money market funds provide stability and income in a slowing economy.
Investors can use the yield curve as a tool to assess general economic conditions and adjust their investment portfolio accordingly.
If the economy is growing, investors can choose to adjust their asset allocation to be more aggressive. Conversely, if the economy is slowing down, investors may adopt a more defensive allocation.
