Inverted yield curve, what does that mean for precious metals?

Since the beginning of last year, interest rates have risen sharply worldwide, but in recent months we have seen a change in the trend. Long-term government bond yields are now falling faster than short-term bond yields, creating a Inverted yield curve. In fact, the yield differential between 2-year and 10-year bonds has not been as large since 1981 as it is now. And that doesn't bode well, because a recession often follows shortly after an inverted yield curve. What does this phenomenon mean and how does it affect the economy and the prices of precious metals?

Under normal market conditions, people pay more interest to borrow money for the longer term than for the short term. When investors expect more economic growth and higher inflation, they want to be compensated with a higher interest rate. But if the economic outlook becomes uncertain and inflation eases, long-term interest rates fall. It may even fall below the level of short-term interest rates. In that case, we speak of an inverted yield curve.

Inverted yield curve

Investors look at the yield on 10-year government bonds and compare them to the yield on bonds with shorter maturities, usually two years or three months. The difference between the 2-year and 10-year yields in the US has been negative since July last year and was even the largest since September 1981 at the beginning of March, at more than 100 basis points. At the time, the economy was in a recession that would last another year, until November 1982. Since then, there have been more frequent periods when the 2-year yield has been higher than the 10-year yield, as the blue line on the chart below shows.

These periods invariably proved to be a harbinger of a recession. Every time the yield curve turned negative, a recession followed, characterized by lower consumption and rising unemployment. The last time this happened was in 2020, when the yield curve inverted for a very brief moment. In recent months, the interest rate differential has widened to record highs, suggesting that another severe recession is coming. However, historical data shows no correlation between the extent to which the yield curve inverts and the severity or duration of the recession that follows.

Inverted yield curve is often a harbinger of a recession with rising unemployment (Source: Gameoftrades)

Reliable indicator?

Inverting the yield curve is a fairly reliable indicator. Every recession in the United States since 1955 has been preceded by a negative interest rate differential between the 2-year and 10-year Treasury bonds. Typically, there was 6 to 24 months between the yield curve inversion and the onset of the recession. In the last six recessions, this took a little longer on average, namely 6 to 36 months.

The inversion of the yield curve is therefore a valuable indicator, but it is not 100% reliable. For example, since 1900 there have been a total of 28 inverted curves, 22 of which actually resulted in a recession. In six cases, the recession did not materialise.

What does this mean for precious metals?

Research has shown that periods when the yield curve inverts tend to be favorable for precious metals. Analyst Tavi Costa of Crescat Capital Analyzed the price movements of the US S&P 500 stock index and gold after every substantial inversion that has taken place since 1970. This showed that gold performed much better than the stock market on average after these periods, as the yellow line in the chart below shows. An extreme outlier was the recession of 1973-1974. During this period, the ratio between the Gold price and the stock market totaled 147%.

The green line in the chart below shows that gold is also outperforming the stock market in this phase. According to Costa, the upside potential for precious metals is very high, because just like in the period 1973-1974, there is again a strong overvaluation of equities. He expects the precious metal to catch up that may resemble the 1973-1974 movement, as the blue line in the chart below shows. In the wake of gold, the Silver price likely to rise with it.

Of course, past performance is no guarantee for the future, but the outlook for precious metals looks very favorable based on this analysis. Macroeconomic conditions for precious metals are also favourable, with a banking crisis that could return like a peat fire and the shift from a unipolar to a multipolar world order in which the dollar's role as a world reserve currency is challenged.

Gold price usually rises after a yield curve inversion (Source: Tavi Costa)

Disclaimer: Holland Gold does not provide investment advice and this article should not be considered as such. Past performance is no guarantee of future results.