Upside Down – Another Yield Curve Inversion - August 19, 2019

The yield curve plots the yield of a bond, say Treasuries, against various maturities. In a normal environment, a longer maturity equates to a higher yield (blue line below). That’s not the case today, as the graphic below illustrates (red line).

On Wednesday, the 2-year yield briefly popped above the 10-year for the first time since late 2005 (St. Louis Federal Reserve). Algorithm-based trading programs quickly took note, and the Dow closed down 800 points (MktWatch data).

Why the adverse reaction? While the timing is in question, an inversion of the yield curve has been an excellent predictor of a recession – see Table 1.

Does an inversion cause a recession? It’s possible that some banks may begin to restrict lending because the spread between the cost of paying interest on deposits and what’s earned on loans narrows. But most economists simply believe that an inversion is a signal from the bond market that rates will fall in response to eventual economic weakness.

However, note in Table 1 that stocks have historically moved higher even after this recession indicator flashed red.

In part, investors haven’t been as concerned about inversions in past cycles. In part, the average recession began 21 months after the curve inverted, but investors attempt to price in economic conditions roughly 6-9 months out. In part, predicting a recession is not an exact science.

It’s possible the yield curve may be sending a false signal. For now, we’ve only had a very mild intraday inversion. The 10-year/2-year has yet to close in ‘inverted territory.’

Still, the temporary inversion didn’t occur because the Fed jacked interest rates too high, pushing the short end above the long end.

Instead, longer-yields have been falling in response to global economic uncertainty, and expectations the Fed will cut interest rates.

Plus, yields in developed countries are much lower than U.S. yields, which encourages foreign investors to seek higher returns in the U.S., which pushes yields at home lower.

If that’s the case, the yield curve may not be sending a reliable recession signal, as it’s being distorted by foreign buyers. In fact, falling yields at home may encourage economic activity.

Today, U.S. manufacturing is weak, but consumer spending, which makes up most of the economy, is strong. We had another confirmation on Thursday that the consumer remains engaged when July retail sales were released by the U.S. Census.

Apart from the yield curve, conditions that normally precede a recession aren’t in place today. These include rising interest rates, rising inflation, a credit squeeze (difficulty for businesses and consumers to obtain loans), and an asset bubble.