Yield Curve: The Little Line That Could

By Teodor Teofilov

In 1980 the US economy went into a recession. But that recession actually could have been predicted, if a very specific little line was taken into consideration.

Graph by Teodor Teofilov, Data from U.S. Department of Treasury

Normally, the line in the picture above points slightly upward — like, in Sept 1977. About a year later, in Aug 1978, it started pointing the other way, just slightly, and then not long after that came the 1980 recession. This happened again in 1988, in 2000 and in the mid-2000s as well.

Graph by Teodor Teofilov, Data from U.S. Department of Treasury

In August, the yield curve inverted, and although to most people this sounds extremely boring and mundane, economists freaked out. Bloomberg noted that the same thing happened in the U.K. and that “alarm bells are ringing louder in bond markets,” while CNBC referred to it as a “recession warning.”

What exactly is this yield curve and why does it have experts freaking out over it?

The Special Line

According to Investopedia, the “yield curve is a line that plots the interest rates at a set point in time of bonds having equal credit quality but differing maturity dates.” But what does this mean exactly?

It all starts with a U.S. treasury bond — an agreement that says that if you lend the federal government $100, they will pay you interest while they hold onto your money until the date they agreed to pay you back. The longer that you let the government hold your money, the higher the interest rate and the more money you get.

However, most people don’t actually buy bonds from the government, but instead they buy and sell them to and from each other in the secondary market. This means that the prices vary depending on the demand for the specific bond. Simply put, the profit you can make is in a state of constant fluctuation and changes every day. Follow these transactions and you get a line that shows what different bonds yield, or the yield curve.

Usually this line points upward.

Sometimes though you have investors that think that there might be an economic downturn coming in the near future. If they are right, it means that if they purchase a two-year bond, they might get their money back in a bad economy, leaving them with nothing good to re-invest in. This will make the two-year bond less lucrative to them. If a lot of people think the same way, the demand for this type of bonds will go down and they will start selling for cheaper.

Now that this bond is cheaper, it will have a better return relative to the low cost. This same investor that thinks that the economic turmoil is coming shortly will rather invest in a longer 10-year bond that pays out later, because they might think the economic struggle will be over then. This causes the 10-year bond to be more popular and in turn more expensive, yielding a lower return.

If there are enough investors that act in this way, the yield on long-term bonds, which is almost always higher than short-term ones, can actually sink lower. If you plot the curve now, it will be inverted and point downward. It will look like the Aug 1978 yield curve.

Graph by Teodor Teofilov, Data from U.S. Department of Treasury

This acts as a sort of mass physiological phenomenon, where investors think that an economic downturn is just around the corner.

Now this on its own wouldn’t amass to much, but the yield curve has been inverted before every recession in the U.S. since 1955. However this can happen months or even years before the actual recession starts, as is the case with the Aug 1978 yield curve inversion, with the recession starting in Jan 1980. This link between the inversion and recessions has investors view the yield curve as a strong predictor that a recession is coming in the near future.

So is a recession coming?

Not necessarily. The popular signal of the inverted yield curve (when the two-year bond yield tops the 10-year one) has given two false-positives since the 1950s and it is possible the one today is also a false signal.

“There have been a couple of false positives — two in fact,” Eric Elbell, the director of research for Gallagher’s Investment and Fiduciary Consulting arm, told Markets Insider.

No recession followed the curve inversion in 1965. Another exception was in mid-1998. According to JPMorgan Asset Management, one major factor that caused the false positive in 1998 was that “the Federal Reserve (the Fed) paused their rate hiking cycle and therefore relieved pressure off the front-end of the curve and a recession did not occur for nearly three years.”

Although an inverted yield curve has been a useful indicator for recessions, it can be distorted by quantitative easing.

“The yield curve may have lost its predictive power if it no longer provides a signal about the stance of policy,” stated Karen Ward, the Chief Market Strategist for EMEA at J.P. Morgan Asset Management, in a post.

It should also be noted that because of stable low inflation and lower population growth rates, the yield curve has become flatter over time in developed countries. This means that if the curves are flatter in general, then inversion can happen because of random trading noise that isn’t necessarily a signal for a recession.

“You can’t just look at the seven-for-seven track record. For example, you could have an indicator that fires every quarter (always forecasting recession). It is correct but it has a lot of false signals,” said Harvey, now a finance professor at Duke University’s Fuqua School of Business, to Duke Today.

The yield curve inversion this time might be a false alarm and needs to be taken into account with other indicators to be able to track the health of the economy and whether there is an economic downturn around the corner. We could see market behavior based on fear of the yield curve that could lead us into recession, but it may be that the only thing we have to fear is fear itself.

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