Incoming Recession? What to Know About a Yield Curve Inversion

Government bonds

As March raps up and spring gets underway, plenty of big stories have been filling newspaper’s front pages. From the ongoing issues of Boeing’s 737’s to the end of the Mueller probe to more accusations against Facebook, there has been plenty to fill headlines over the past few weeks (Yet, somehow CNN is still only talking about the 2020 election…).

I would not be surprised then if many people missed a little market development of the past week: the inverting of the yield curve.

Some Background

In order to understand what a yield curve inversion means, let’s first get an idea of what a yield curve is.

The U.S. has numerous different bonds that investors can buy, each varying by when they mature ( 3 months, 1 year, 2 years, 10 years, etc) and their yield, or the interest paid to the purchaser of the note. For example, on March 27th, a 3-month treasury bond had a yield of 2.44% while a 1-year treasury bond had a yield of 2.40%

The yield curve, as seen below, is a plot of bond’s yields and maturities. The graph below is what the yield curve looks like in a regular period of growth. Notice how the higher maturities have higher yields. This occurs since longer term bonds have a bit more risk. There is a longer period of time where something could go wrong and you could lose your money, so the slightly higher yield is essentially the extra pay needed to compensate for said risk.

Yield_curve_20180513
Graph 1

On top of this, there is usually higher demand for bonds that pay out faster, pushing up the prices of short term ones. By the nature of how a bond works, as prices rise, yields fall, helping to keep short term yields lower than long term yields.

So what is an inverted yield curve then? This is when short term bonds (3-month, 1-year) have higher yields than longer term bonds (10-year). An inversion occurs when investors believe there is a bump in risk in the short run, like an imminent recession. If the economy is about to contract, then a bond that pays out after growth returns becomes more appealing. Short term bonds need to offer higher yield since they might mature in an economic downturn.

Going back to bond demand, if longer period bonds are expected to mature after a perceived recession when economic stability returns, then demand for them will rise. This pushes up their prices and brings down their yields, helping to bring them below short term rates.

My second graph below is an example of an inverted yield curve.

Screen-Shot-2019-03-25-at-2.09.50-PM
Graph 2

(For some more on yield curves, here is a Wikipedia page and an explanation from Fidelity to further your understanding.)

Implications

So why is an inversion note worthy? Unfortunately, an inverted yield curve has preceded every recession in the past 40 years. This can be seen in the chart below from FRED (negative spread=inversion, grey columns are recessions).

fredgraph (1)
Graph 3

I can envision people’s reaction to this: if an inversion always precedes a recession, then we must be on the brink of one!

This is where some important distinctions come in. Preceding does not mean immediately after. Just because an inversion happens before every recession does not mean the contraction will occur the next day.

Take a look at graph 3 again, specifically at the time between when the line goes negative and when the recession starts. It is in most cases not immediate, and often there is a long gap between inversion and the recession.

The 1990-91 recession began around July of 1990, when unemployment first started to rise. The preceding inversion happened in June of 1989, over a year before. The Great Recession really began around December of 2007 when unemployment first broke above 5%. The yield curve first inverted well over a year before this in July 2006.

So yes, an inverted yield curve is a precursor to a recession. Do not let it fool you into thinking that we are about to fall off a cliff, though. The economy will likely grow throughout the course of this year and into next year. We may not even see a recession until 2021, who knows.

Regardless, a yield curve inversion is important to note since it gives us an idea of where we are in the business cycle. Even though a recession still won’t occur for some time, the U.S. is clearly at the back end of the growth period. We will have to wait and see how long it takes for investor’s expectations to come true.

 

 

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