Why the Alarm about Yield Curve Inversions?

Are you sitting down? I’ll pause typing for a moment so you can find a chair.

Good. On Monday, Dec. 10, for the first time in 12 years, the yield (or interest rate) on the five-year U.S. Treasury bond fell below the yield on the three-year U.S. Treasury bond. Alarm bells rang on Wall Street. The rest of us said, “What?”

When the yield on a long-term bond drops below the yield on a short-term bond, it’s called a “yield curve inversion.” Over the last 50 years, the yield curve has inverted six months to a year-and-a-half before the start of each recession. It’s predicted all seven recessions since 1970. Hope you are still sitting.

The U.S. Treasury sells Treasury securities when it needs to borrow money to cover the federal budget deficit. A security is a promise to pay interest and repay the principle after a period of time, from 30 days to 30 years. Short-term securities are called bills; long-term securities are called bonds.

Lenders can sell Treasury bonds in the bond market once the Treasury has its money. The price of a bond can vary up and down, which varies the yield above or below the original interest rate.

Investors consider inflation when they choose what bonds to buy. If inflation is higher, the interest they collect from the Treasury will be worth less. If inflation is lower, it’s worth more.  The return on short-term bills is more certain, because inflation seldom changes much over just a few months. But a 5- or 10- or 30-year bond is different. No one knows with much certainty what inflation will be that far into the future.

The uncertainty about future inflation means that investors usually prefer short-term bills over long-term bonds. That means long-term bonds have to have higher yields in order to get people to buy them. Long-term bonds almost always have higher yields than short-term bonds and bills.  The set of short and long-term yields on any day is known as the yield curve, and it usually slopes upward.

The yield curve is steep if long-term yields are way higher than short-term yields. It’s flat if the difference is small. The slope of the yield curve depends on investor expectations of inflation. If investors think that future inflation will be higher, they’ll invest short-term, and long-term yields will have to rise to attract money. If they think future inflation will be lower, they’ll invest long-term to lock in higher rates, but that makes long-term rates fall. Inflation falls in recessions, so an expectation of lower inflation means investors are pessimistic.

Federal Reserve policy plays a role. The Fed adjusts the federal funds rate, which is the interest rate at which banks lend to each other overnight. Short-term Treasury bill rates move in lockstep with the federal funds rate. When the Fed is raising rates, and investors get pessimistic about the future, short-term yields rise and long-term yields fall. The yield curve inverts. That’s what happened on Dec. 10.

Economists pay most attention to the difference between the three-month Treasury bill and 10-year Treasury bond.  It hasn’t inverted yet, but the difference between the two has narrowed over the past year, from 1.2 percentage points to 0.5 percentage points.

The 10-year/3-month yield difference inverted on Aug. 2, 2006. The Great Recession started one year, four months later, in December 2007. It inverted on July 27, 2000, and the 2001 recession started eight months later in March. You get the picture. Inversions have been reliable predictors of recession.

Yield curve inversions don’t cause recessions. They’re just a way of measuring what a whole lot of informed people think about our economic future.

That doesn’t mean a recession is coming for sure. Sometimes the economy changes and indicators stop working. And there was that time back in 1966 when the yield curve inverted and a recession did not follow within a year and a half. The Fed had started raising interest rates, but then reversed course.

You can be sure, though, that Wall Street and policymakers will be paying close attention to the yields on 10-year and 3-month Treasuries. If that one inverts, maybe you’d better lie down.

Author: Larry Deboer
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