Recently, investors and economists have focused increased attention on bond market yield curves, which have proven to be a compelling predictor of an upcoming economic recession.
The yield curve is the measure of the difference between short-term and long-term interest rates on government bonds. In a healthy economy, interest rates on long-term (typically, ten-year) bonds are generally higher than rates on short-term (often, two-year) bonds. This rate increase from short-term to long-term bonds creates a positively sloping yield curve (see Figure 1) which reflects investors’ expectations that economic growth will, among other things, ultimately inflate prices.
Currently, however, the yield curve is flattening, meaning that the disparity between short-term and long-term interest rates is diminishing (see Figure 2). As a recent New York Times article explained it, the yield curve has been flattening lately because “long-term bond yields have been stubbornly slow to rise – which suggests traders are concerned about long-term growth – even as the economy shows plenty of vitality.” Additionally, the Federal Reserve has been raising short-term interest rates, and as a result, the short-term and long-term rates threaten to collide.
The growing concern is that if this trend continues, and the short-term rates meet with, and eventually rise above, long-term rates, then the yield curve becomes inverted, meaning that it reflects a downward slope (see Figure 3). Such a yield curve inversion has occurred in the two years preceding each of the nine officially designated recessions since January 1955, according to research by the San Francisco Federal Reserve Bank. It is worth noting that the current gap between two-year and 10-year United States Treasury notes fluctuates between thirty and forty basis points. The last time the yield curve came this close to inverting was in 2007, just before that financial crisis erupted. For reference, a yield curve in a healthy economy can exceed 280 basis points.
Yet, the yield curve’s prophetic function might be overstated. The fear that the yield curve indicates a recession may create a self-fulfilling prophecy. Investors’ pessimism about market growth rates is what causes the yield curve to flatten in the first place. Therefore, under some views, mounting concerns about yield curve trends, alone, may be sufficient to drive investors to make additional purchases in long-term government bonds, which only further flattens the curve.
Moreover, there has been at least one false positive, in 1966, in which the yield curve inverted but was not followed by an official recession. At least one study, published by an economic think tank, has concluded that inverted yield curves are actually “not rare,” and that “inverted yield curves per se have not been a serious problem for savings and loans . . . except when they were clustered in a few consecutive years with large negative spreads.”
Publications from 2007 discussing yield curves reveal some skepticism as to whether the inverted yield curve is indeed guaranteed to signal a recession. The above study, which was published in March 2007, ironically concluded: “[D]epository institutions are in overall good financial condition and . . . regulation has been significantly improved. Despite concerns over yield curve inversions and weaknesses in the real estate market, the problems emerging today are not of sufficient magnitude or sufficiently widespread to be comparable to those that arose two decades ago and we are unlikely to face a recurrence of the savings and loan crisis of the 1980s. The developing real estate problems . . . are unlikely at the moment to lead to any significant and costly failures.” Though not an oracle, a flattening yield curve still deserves to be considered seriously today, particularly if it becomes inverted.
Figure 1: A “normal” yield curve for U.S. Treasuries from February 29, 1996, reflecting a yield spread between two- and ten-year bonds that was approximately 68 basis points (bps), and rates that were substantially higher than today, with the two-year yielding more than 5.42 percent.
Figure 2: The current yield curve (June 30, 2018) is in blue and is compared against the yield curve from January 1, 2018, which is in red. Although yields have risen for every maturity, short-term yields have risen faster, with the two-year adding nearly 65 bps while the 10-year has increased by only 46 bps. The longest-dated U.S. Treasuries, the 30-year bonds, have seen their yields rise by even less – barely 25 bps.
Figure 3: The U.S. Treasuries yield curve was inverted on November 30, 2006, after the Federal Reserve had undertaken a two-year effort to “normalize” short-term rates. The yield spread between the two- and ten-year bonds was negative by more than 15 bps, a factor that contributed to the downfall of Bear Stearns and Lehman Brothers in 2008.