The news media has been doing its part to draw attention to a boring yet key economic indicator: the yield curve.
The yield curve serves two functions. First, it’s a simple way to show bond investors the price of borrowing money over the short term vs. the long term. The curve commonly tracks U.S. Treasuries that carry three-month, two-year, five-year, 10-year, and 30-year maturities.
However, the yield curve also measures bond investors’ feelings and fears about risk, thus making it a key metric that can be used to predict recessions.
When the yield curve “inverts,” that means the economy and the stock and bond markets could be headed for a strong bout of volatility or worse, a signification retraction. So when you hear stories about the inverted yield curve, pay attention. It’s a well-seasoned warning sign that has a reliable track record.
What Is a Normal Yield Curve?
Most often, short-term bonds carry lower yields than intermediate or long-term bonds, reflecting the simple fact that an investor’s money is at less risk. Less risk, less income for the investor. This also applies to folks who invest in certificates of deposit.
Those bond investors who squirrel away their money over several years are taking on a much bigger risk, as bond issuers could default and stiff them.
Thus, they should be rewarded with higher yields. In other words, if you lent your money to a bank, corporation, or government for 10 years, you’d want to get paid enough to compensate yourself for the forgone opportunity to lend that money somewhere else at a higher rate.
This is how the bond market typically works — and how it’s reflected in the normal yield curve chart, which slopes upward from left (yield rates) to right (length of bond maturities). When the yield curve functions like this, it means bonds investors expect a normal pace of economic growth.
What Is an Inverted Yield Curve?
Imagine again an image of the normal yield curve chart. If it slopes downward from left to right, you’ve got a problem.
A yield curve inverts when the premium, or the spread (how much more long-term bonds pay over short-term bonds), drops to zero or even turns negative.
For example, you are in an inverted yield curve world when a 10-year U.S. Treasury bond pays a lower yield than a two-year note. This is what happened in August of 2018, feeding market fears that a recession was on the horizon.
Since the inverted yield curve also reflects investor emotions, you couldn’t help but think that this reflects investor madness.
It’s downright counterintuitive to earn less — or even nothing — on long-term bonds. But that’s exactly what’s happening now as long-term Treasuries investors, expecting worse, lock in whatever yield rate they can get before all hell breaks loose.
These investors also are willing to get virtually no income because they don’t expect inflation to increase. Keep in mind that inflation and healthy economic growth typically go hand in hand.
The other force driving the inversion is the mighty Federal Reserve, the all-powerful establisher of interest rates. The problem stems from the short end of the yield curve (i.e. short-term bonds). This is where the Fed wields its greatest power over interest rates.
At the beginning of 2019, the federal fund rate (the rate that the Fed charges banks to borrow money and that influences what rates we pay for credit cards, car loans, and mortgages) was around 2.5 percent.
During 2022, the Fed is expected to hike interest rates three times, according to Reuters, juicing the appeal for short-term bonds. But in July 2019, the Fed cut rates slightly for the first time since 2008.
The move spooked long-term investors who see cuts as an acknowledgment that the economy needed help.
And the Fed may cut rates further as economic and military tension in Europe increases. As I said before, the yield curve really reflects investor emotions, and the inversion reflections the fear that the U.S. and global economies are headed for trouble.
Why We Can’t Ignore the Yield Curve
Peter Navarro, Former President Trump's trade adviser, describes the yield curve the best. “The yield curve is such a powerful forecasting tool precisely because it embodies the collective wisdom of millions of highly sophisticated investors quite literally putting trillions of dollars on the table in highly intelligent speculative bets on the direction of the business cycle,” he says.
And if the direction points downward, those bets are off. The yield curve, in its obviously inverted state, is more than some abstract economic metric. It has real-life implications when it comes to our financial system.
For instance, it can diminish banks’ willingness to lend money because they can’t expect much profit if they think long-term interest rates will pay less than short-term rates. Better to hunker down, must be the lenders’ sentiment, I guess.
Is It a Reliable Gauge for a Recession?
The inversion between the 10-year U.S. Treasury bond and the two-year Treasury bond has been a harbinger of every U.S. recession over the past 50 years. Seven times, in fact. And these recessions typically manifest between three months to two years later.
In 2018, we had several yield-curve inversions. And although our current recession is linked to causes outside the market, it's worth heeding these warnings as they can indicate a future decline of economic growth and U.S. prosperity. You’ve been warned.