An unusual event occurred last Friday: 10-year Treasury yields fell below 90-day Treasury yields. Why is this bad? Economists consider the inverted yield curve to be a reliable predictor of a coming recession.
Is This Actually a Big Deal?
(Short version) Yes. The joke about predicting 30 of the last 3 recessions does not apply here.
There’s been a lot of breathless doomsday coverage from the media, but few in-depth explanations. In this article, we’ll cover:
- What causes the yield curve to invert
- How the inverted yield curve doesn’t just predict recessions, it can cause them
- How the Fed might turn it around
- Why there could be a strong stock rally
- Why some say this time is different
Why Is This a Big Deal
(Longer version) Every recession in the past 60 years has been preceded by a yield-curve inversion (specifically by the one year Treasury yield surpassing that the 10 year Treasury yield).
More tellingly, every inversion (with one exception) has been followed by a recession.
The single exception occurred in the mid-1960s. In the 60s, the economy did slow drastically following a yield curve inversion, but fiscal stimulus prevented a full-blown recession.
The Yield Curve Inversion Explained
A bond is a chunk of money an investor lends to a company or to the government. In return for lending money, investors collect interest. The annual return investors receive is called the yield.
For example, if you purchased a $100 bond with a 5% coupon rate, then the yield is also 5%.
The yield does not always equal the interest rate because bonds sell on the secondary market. If the original price of the bond drops to, say $80, the yield becomes 6.25% (you still collect $5 in interest because interest is calculated from the original face value).
A yield curve is simply a graph where the y-axis is the bonds’ yield, and the x-axis is the maturity.
Below is what a normal, healthy yield curve looks like:
In a healthy market, bonds with longer maturities trade at higher yields and bonds with short term maturities trade at lower yields.
This is an inverted yield curve. The yield curve inverts when bonds with short term maturities yield more than bonds with longer maturities.
You can see the 10-year Treasury yields 2.44%, but the three-month Treasury yields a slightly higher return of 2.46%.
There are many yield curves we could look at, such as the 2-year and the 10-year, but the San Francisco Fed as well as the professor who “discovered” the significance of the yield curve inversion, Professor Campbell Harvey, specifically consider the 3-month/10-year to have the most predictive power. The last time the 3month and the 10-year yields were inverted was 2007.
What Cause the Yield Curve to Invert?
The inverted yield curve is caused by two moving parts: long term yields decreasing and short term yields increasing.
Short Term Yields Increase: Blame the Fed
The main cause of the inverted yield curve is the Fed has been steadily increasing the federal funds rate, which affects short-term Treasury rates (though they paused the raises in March).
The Fed does this to prevent a booming economy from overheating. If interest rates are too low, capital is easy to come by. This incentivizes speculative lending and can overheat the economy.
In 2017, the New York Fed surveyed 23 broker-dealers to gauge market sentiment. The respondents said they felt the Fed rate increases explain two-thirds of the decline in the yield curve’s slope since December 2015.
Long-term Yields Decrease: Blame the Bond Traders
The reason that long-term Treasury yields are decreasing is investors are buying up bonds and driving up bond prices. When prices go up, yields go down.
For example, imagine that bond which originally issued for $100 with a 5% interest rate now sells on the secondary market for $120. This drives the yield down from 5% to 4.1%.
Why are investors parking money in long-term Treasuries? The financial markets think the economy is headed for a rough patch. Bond traders anticipate a recession and think the Fed will lower interest rates in response. By investing ahead of this anticipated interest rate slash, traders lock in a higher rate.
Can the Inverted Yield Curve Cause Recessions?
In addition to predicting recessions, they can also cause recessions. There are two reasons for this.
First, inverted yields cause banks to tighten lending.
Banks make money by borrowing short-term and lending long-term and profiting off the difference in yield.
They pay customers a certain interest rate for the money in their checking and savings accounts. For checking accounts it is 0.06% on average. They then lend out this to homebuyers or small businesses at a much higher interest rate.
When short-term interest rates become equal or even larger than long-term interest rates, banks can’t much of a profit lending out money. This can lead banks to extend less credit.
In October 2019, the Fed asked banks how they would respond to a moderate inversion of the yield curve. Senior loan officers responded they would tighten lending across the board.
Why is this important?
When it becomes harder for businesses to borrow, many companies cancel or delay projects and hiring. Businesses lose access to credit, which in turn causes layoffs. When this happens, it takes about a year, on average, for the U.S. economy to slip into a recession.
A Self-Fulfilling Prophecy
Ironically, the fact that so many people think the yield curve inversion means a recession is coming can itself cause a recession.
When consumers anticipate a recession, they spend less. When consumers spend less, business lay off workers, thus starting the vicious downward cycle.
Alternately, when businesses perceive a recession on the horizon, they scale back hiring plans and capital investments. According to the Duke CFO survey, 82% of chief financial officers believe a recession will have started by the close of 2020. When CFOs worry, hiring slows, capital expenditures drop, and companies tighten their belts.
Before You Panic
We haven’t given you much cause for hope yet, but there are a few reasons you shouldn’t panic.
1. It’s Only Been Two Days
Professor Campbell Harvey who identified the predictive powers of the 3-month/10-year curve, also determined that the curve needed to stay inverted for at least 12 weeks to be a solid signal.
While it looks like the curve will stay inverted, we aren’t there yet and it could still change.
2. Stocks Won’t Tank Overnight
Even if the yield curve stays flat or inverted for an extended period of time, the stock market won’t tank overnight. Historically, it took between one to two years after the yield curve inverted for the recession to start.
During the time between the yield curve inversion and the start of the recession, the stock market rallied double digits in most cases (FYI most gains in a bull market are made in the very late stages).
Mark Kolanovic, global head of macro-economic research at JP Morgan, said “Historically, equity markets tended to produce some of the strongest returns in the months and quarters following an inversion. Only after [around] 30 months does the S&P 500 return drop below average.”
He notes the following patterns from the inversions and ensuing recessions in 1978, 1989, 1998 and 2006:
- Given the low 10 year yield, investors reallocate to equities
- Following the inversion, the Fed stops hiking rates which also boost equity valuations
- As a result, the stock market performance is very high after the first onset of the first inversion.
- Given the strong equity returns and high valuations, the Fed resumes hiking rates, pushing the market lower and driving a recession.
3. The Fed has Backed off Raising Rates
The Fed appears to be cautious about recessionary headwinds. They paused raise rates in their March meeting. Charles Evans, Chicago Federal Reserve president, said he would even support a rate cut if the economy softened even more or if inflation decreases too much.
In fact, Ray Dalio, founder of Bridgewater Associates, a hedge fund with _ assets under management, said he thinks a full-blown recession is less likely given the “easier stance” taken by the Fed and other central banks.
Is This Time Different?
- Some argue that though a yield curve inversion has accurately predicted recessions in the past, this time it’s different.
Some financial analysts think the inverted yield curve is the result of quantitative easing, a once in a lifetime (knock on wood) monetary policy the Fed employed in the wake of the 2008 financial crisis.
From 2008 to 2014, the Fed bought $4.5 trillion dollars worth of long-term Treasuries and mortgage-backed securities to stabilize their prices. This pushed long-term Treasury prices up and yields down.
In fact, one model published by the Fed suggests that QE pushed down the term premium on 10-year Treasury bonds by 1%.
The Fed has been unwinding its balance sheet since 2017, as the bonds it holds mature. Some speculate this could send the term premium back up over time and unflatten the yield curve.
It Doesn’t Happen in Japan
Though the yield curve inversion has preceded every recession (minus one) in the US, that hasn’t been the case in other countries. Japan has had many recessions, but it has never experienced an inverted yield curve.
Meanwhile, Australia has experienced four yield inversions, but none of them were followed by a recession.
UBS Wealth Management’s chief economist, Paul Donovan explains his skepticism this way: “The myth also suggests that the US yield curve has some magic ability to forecast the future, but other country’s yield curves do not. The UK yield curve has inverted for years at a time with no recession. The Japanese yield curve has not inverted since 1991, in spite of one recession after another. … If bond yield curves can predict, they should be able to predict everywhere. They do not.”
The four most dangerous words in investing are “This time it’s different.” We heard similar arguments ahead of the 2008 recession.
In fact, Alan Greenspan, Fed chair at the time, testified in 2006 before the Joint Economic Committee of Congress that there was no need to worry about an inverted yield curve. It had “lost its ability to forecast recessions.”
We don’t doubt the inverted yield curve casts a real shadow over the markets and economy. At the same time, the news cycle makes it seem like a recession is coming tomorrow. If the past is any indicator, it should be on the order of months or years away, not days or weeks.
Investors should focus on getting their finances in order, paying off debt, and making sure their investments are allocated to different asset classes in line with a risk profile suitable to his or her lifestyle.