Does the inverted yield curve mean a US recession is coming?

As inversion reaches deepest level since early 2007, some economists are sounding alarm bells about an imminent crash.

Inverted yield curve

United States Treasury yields took a dive on Monday, as fears mounted over an escalation of trade and currency tensions with China. Along with renewed concerns about a global economic downturn, the uncertainty sparked a fresh round of buying US government debt and other assets that are perceived to be less risky.

The three-month US Treasury bill rate became 32 basis points higher than the sinking 10-year yield – normally the greater of the two – and reached the widest difference since April 2007.

What is yield?

Yield describes the money earned on an investment over a particular timeframe and is expressed in terms of a percentage based on the initial amount of a security. It includes interest and dividends received from the investment. In other words, it is a measure of cash flow and is usually calculated on an annual basis.

What is a yield curve?

A yield curve is a chart showing the interest rates for bonds with equal credit quality but different maturity dates. The yield curve most commonly cited shows three-month, two-year, five-year, 10-year and 30-year US Treasury debt. Investors consider this curve the benchmark for other rates in the market, such as bank lending rates and mortgage rates.

Yield curves from the past
Yield curves show historical rates of interest on United States Treasury bills of varying maturities. The green line for 2011 is the most ‘normal’, while flatter curves in 2007 (orange) and 2018 (blue) point towards recession. The line for 2000 (red) is inverted, demonstrating highly negative economic headwinds [Federal Reserve Economic Data/Wikimedia Commons] 

What is an inverted yield curve?

A yield curve’s shape helps investors understand how interest rates are expected to change in the future. It also indicates likely economic fluctuations. Due to the “duration” risks of holding assets over time, a normal yield curve shows that bonds with a longer maturity have a higher yield – and pay more interest – than short-term bonds. Investors usually demand higher rates of return if their money is locked up for longer.

On an inverted yield curve, short-term yields become higher than long-term yields. Put another way, this occurs in an interest-rate environment where long-term debt instruments offer lower rates of interest than short-term debt instruments.

So what does the difference mean?

When the US economy starts moving from healthy growth to being primed for a contraction, the yield curve usually first flattens and then inverts. As short- and long-term yields become closer to each other, there is an increasing likelihood that a recession is coming.

Inversion between the two maturities has preceded every US recession in the past 50 years and is considered an accurate predictor of when the business cycle has shifted. This has occurred seven times over the last half-century, with inversions being followed a couple months to two years later by a recession. The inverted yield curve has only given a false signal once.

Are we heading towards recession?

After flattening out for a year and beginning to invert in March, the yield curve in the US had already inverted for a whole three months by June. But not all economists believe a recession is in the works – despite that three-month inversion. Unemployment is at a historic low, consumer demand remains robust, and the US equity market – until very recently – seemed to be chugging along.

Why does the curve invert?

As investors expect longer-maturity bond yields to drop even lower down the road during economic troubles, they rush to buy them sooner. They want to lock in the yields, driving up demand and price for longer-maturity bonds. This in turn helps drive down the demand and price for short-term bonds. It usually means that investors are becoming less sure that economic growth will continue.

How do bond prices relate to their yields?

When bond prices increase, their yields decrease. These bond attributes move in opposite directions because – when interest rates go down – bonds that are already paying higher rates are more attractive and can command a higher price. An inverted yield curve may also predict lower interest rates in the pipeline, as investors move back towards longer-term securities.

Why is the three-month Treasury bill important?

The three-month Treasury bill just represents short-term securities and reflects what investors are expecting from the near future. But there is nothing exceptional about this particular instrument.

How about the 10-year yield?

As a stand-in for longer-term debt instruments, the 10-year Treasury bill simply represents how investors are thinking about the more distant future. The 10-year rate dropped to 1.74 percent on Monday, 0.32 percentage points less than the rate on the three-month bill. But this could dip even further, especially as central banks around the world continue to slash interest rates.

Source: Al Jazeera, News Agencies