America's inverted yield curve - Time to panic?
What has happened?
Three times over the previous few weeks the US yield curve has inverted.[i] More specifically, the yield on 10-year Treasury bonds fell below the yield on 2-year bonds. Investors are worried as the last time this occurred was just before the GFC, and historically speaking the US yield curve inversion is one of the most accurate signals of an impending US recession. These fears manifested into an immediate fall of roughly 3% in US and Australian shares in response to the initial inversion.[ii]
What is the inverted yield curve?
SThe yield curve refers to a graph that displays the yields of US Treasury bonds with different terms to maturity. The ‘yield’ of a bond refers to the return that investors will receive from the bonds, expressed as an annualised interest rate. When the yield curve is normal it slopes upwards from left to right. This shows that long-term bonds reward investors with greater yields compared to shorter bonds. This makes sense, as bonds with longer maturities expose lenders to greater risk, and it means they are separated from their money for a longer period. When the yield curve inverts however, it means that longer term bonds are offering lower yields than short-term bonds.
What does this mean?
The main reason inversion causes panic is its signal about market expectations. The US Treasury Bond market is one of the largest, most liquid markets in the world with roughly US$500 billion of trading occurring every day.[iii] Participants in this market include governments, institutional investors and individuals all over the world. Accordingly, it serves as a strong indicator of what everyone thinks is going on, and when inversion occurs it generally means a few things.
Firstly, it signals that the market thinks long-term interest rates are going down. This is worrying as the US Federal Reserve generally cuts interest rates in response to weak economic conditions. Alternatively, the inverted curve could signal that investors think current interest rates are too high and are therefore hindering growth. By accepting lower long-term yields, investors also signal that they expect inflation to slow – another sign of a weak economy. Finally, the inverted yield curve signals a flight to quality. Bond yields have an inverse relationship with bond prices, and so lower long-term yields mean prices for long-term bonds have risen in response to greater demand. By choosing government bonds to secure a reliable long-term return, investors signal that they think riskier assets such as shares are going to fall in the future.
Further, the inverted yield curve actually causes growth to slow due to its impact on banks. The basic business model of a bank is to take deposits (short-term loans) whilst lending out long-term loans. Usually this is profitable as the interest paid on deposits is lower than the interest earned from long-term loans. When inversion occurs however, banks start paying more interest than they receive, and so tighten their lending standards and lend out less money.[iv]
Is a recession looming?
Honestly, it doesn’t look good. Since 1955 the US has experienced nine recessions, and they have all been preceded by yield curve inversions.[v] What’s even more troubling is that there has only been one false positive, which occurred in the mid-1960s.[vi] In other words, an inverted yield curve has without exception predicted every US recession in the last 50 years. Even the Federal Reserve Bank of San Francisco admitted in 2018 that the ‘term spread [difference between short- and long-term yields] has a strikingly accurate record for forecasting recessions’.[vii] Indeed, in response to the inversion the Federal Reserve Bank of St. Louis President James Bullard has called for a rate cut, as having an inverted yield curve is ‘not a good place to be’.[viii] Predicting when the recession will occur is not as simple however, with the lag-time between the last five inversions and recessions varying from ten to 36 months.[ix]
Will this time be different?
Some experts believe that this time will be different however. The US Federal Reserve Bank of Richmond suggested that nowadays, potentially due to inflation being under control, long-term yields are naturally lower and so the yield curve is more likely to uneventfully slip into inversion.[x] Additionally, former Chair of the US Federal Reserve Ben Bernanke believes that quantitative easing and other post-GFC policies have distorted the bond market and robbed the yield curve of its predictive powers.[xi] It should be noted however that Bernanke also was unconcerned about the inversion that occurred at the start of his Fed tenure, and we all know what happened next.[xii] Further, many economists including Bernanke’s successor Janet Yellen point to the current strength of the US economy as evidence there is nothing to fear.[xiii] The power of the yield curve however is that it tells us what is coming, not what is occurring. Indeed, research has shown that simple models based off the yield curve are better at predicting recessions than professional forecasters, so it is best to meet these opinions with a healthy dose of cynicism.[xiv]
In summary, we have an
almost foolproof economic indicator which tells us what the global market is
thinking, and it’s telling us a US recession is on the way. There are some
voices telling us not to worry, however they’ve said this in the past and been
wrong, and the research has shown that the indicator is better for predicting
recessions anyway. So yes, it looks like it could be time to panic after all.
[i] Smith, C. (2019). Yield curve inverts after hawkish Fed remarks. Retrieved from https://www.ft.com/content/6c532d0c-c4fc-11e9-a8e9-296ca66511c9
[ii] Chau, D., & Janda, M. (2019). ASX tumbles $60 billion on US recession, China slowdown fears. Retrieved from https://www.abc.net.au/news/2019-08-15/asx-tumbles-$60-billion-on-us-recession-china-slowdown-fears/11416348
[iii] McPartland, K. (2018). Understanding the $41 Trillion U.S. Bond market. Retrieved from https://www.forbes.com/sites/kevinmcpartland/2018/10/11/understanding-us-bond-market/#54b484a41caf
[iv] Wheelock, D. (2018). Can an Inverted Yield Curve Cause a Recession? Retrieved from https://www.stlouisfed.org/on-the-economy/2018/december/inverted-yield-curve-cause-recession
[v] Marte, J. (2019). Recession watch: What is an ‘inverted yield curve’ and why does it matter? Retrieved from https://www.washingtonpost.com/business/2019/08/14/recession-watch-what-is-an-inverted-yield-curve-why-does-it-matter/
[vi] Bezoni, L., Chyruk, O., & Kelley, D. (2018). Why does the Yield-Curve Slope Predict Recessions? Retrieved from https://chicagofed.org/publications/chicago-fed-letter/2018/404
[vii] Bauer, M. D., & Mertens, T. M. (2018). Economic Forecasts with the Yield Curve. Retrieved from https://www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve/
[viii] Imbert, F. (2019). James Bullard says Fed should cut rates because inverted yield curve is ‘not a good place to be’. Retrieved from https://www.cnbc.com/2019/08/23/james-bullard-says-fed-should-cut-rates-because-inverted-yield-curve-is-not-a-good-place-to-be.html
[ix] Bloom, M. (2019). Wall Street strategists tell clients the yield curve inversion is not necessarily signalling a recession. Retrieved from https://www.cnbc.com/2019/08/15/the-yield-curve-doesnt-necessarily-mean-a-recession-will-happen.html
[x] Haltom, R., Wissuchek, E., & Wolman, A. L. (2018). Have Yield Curve Inversions Become More Likely? Retrieved from https://www.richmondfed.org/publications/research/economic_brief/2018/eb_18-12
[xi] Tett, G., & Rennison, J. (2018). Bernanke warns against reading wrong yield curve signal. Retrieved from https://www.ft.com/content/e72fdf28-8a1c-11e8-bf9e-8771d5404543
[xii] Reuters. (2007). Bernanke says inverted yield curve not economic threat. Retrieved from https://www.reuters.com/article/us-usa-fed-curve/bernanke-says-inverted-yield-curve-not-economic-threat-idUSWAT00696320070214
[xiii] Fitzgerald, M. (2019). Janet Yellen says yield curve inversion may be false recession signal this time. Retrieved from https://www.cnbc.com/2019/08/14/janet-yellen-say-yield-curve-inversion-may-be-false-recession-signal-this-time.html
[xiv] Rudebusch, G., & Williams, J. (2009). Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve. Journal of Business & Economic Statistics, 27 (4), 492-503. doi:10.1198/jbes.2009.07213