Investors across the world are reacting to the prospect of a looming recession following the announcement by the US Federal Reserve that interest rates are unlikely to rise this year.
The statement prompted a sell-off of bonds with a short date to maturity, as markets viewed it as a sign that economic conditions in the US are worsening and interest rates could fall.
Such bonds are most sensitive to the performance of the economy and interest rates and the effect of their sell off in lieu for those with a longer maturing date is that the yield curve, which in a healthy economy slopes upwards from left to right, now slopes downwards from left to right.
Every recession but one since the second world war has been preceded by a similar inverting of the yield curve, typically happening nine to twelve months prior to the recession.
Chris Beauchamp, chief market strategist at IG Group, noted the yield curve inversion happened on Friday and caused the FTSE 100 to fall by 2 per cent.
He said: "An inversion of the three-month/ten-year yield curve has been taken as a sign that a recession may be on the horizon, although not upon us yet.
"Combined with weaker US PMIs and some truly dreadful figures from the eurozone, it has been enough to spark another swift, but substantial, move to the downside.
"Yield curve inversion is not necessarily an immediate harbinger of doom, but it will signal that growth concerns are on the rise."
He added: "In another worrying turn, German ten-year bunds have seen their yields turn negative, as investors pile into bonds as a safe haven. It has been a whipsaw week for equities, which is an indication of how conflicted investors are at present.
"Equities have been so strong of late that it makes little sense to abandon the asset entirely, but a sense that things have run too far, too fast is hard to shake off."
Ed Smith, head of asset allocation research at Rathbones Unit Trust Management, said historical evidence showed equity markets peaked four months prior to a recession so investors who respond to the current period of market uncertainty by selling equities were likely to be sacrificing months worth of gains.
He said investors should instead focus on businesses less dependent on the performance of the economy, and buy shares with defensive characteristics.
david.thorpe@ft.com
