CFA Society Singapore
(June 27): The so-called yield curve is perilously close to predicting a recession -- something it has done before with surprising accuracy -- and it’s become a big topic on Wall Street, says The New York Times.
The yield curve is basically the difference between interest rates on short-term US government bonds, say, two-year Treasury notes, and long-term government bonds, such as 10-year Treasury notes. Typically, when an economy seems in good health, the rate on the longer-term bonds will be higher than short-term ones.
The extra interest is to compensate, in part, for the risk that strong economic growth could set off a broad rise in prices, known as inflation. Lately, though, 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.
At the same time, the Federal Reserve has been raising short-term rates, so the yield curve has been “flattening”. In other words, the gap between short-term interest rates and long-term rates is shrinking. On Thursday, the gap between two-year and 10-year US Treasury notes was roughly 0.34 percentage points.
It was last at these levels in 2007 when the US economy was heading into what was arguably the worst recession in almost 80 years. As scary as references to the financial crisis makes things sound, flattening alone does not mean that the United States is doomed to slip into another recession. But if it keeps moving in this direction, eventually long-term interest rates will fall below short-term rates, also known as “inversion”.
An inversion is seen as “a powerful signal of recessions”, as New York Fed President John Williams said this year, and that’s what everyone is watching for. Every recession of the past 60 years has been preceded by an inverted yield curve, according to research from the San Francisco Fed. Curve inversions have “correctly signalled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession”. Some economists on Wall Street think the economy could be growing at around a nearly 5% annualised clip this quarter. But if the current economic vigour is only reflecting a short-term stimulus coming from the Trump administration’s tax cut, then some kind of slowdown is to be expected.
Financial markets can sometimes sniff out problems with the economy before they show up in the official economic snapshots published on gross domestic product and unemployment. Another notable yield curve inversion occurred in February 2000, just before the stock market’s dot-com bubble burst. In that sense, the government bond market isn’t alone. Stocks have been in a sideways struggle since the S&P 500 last peaked on Jan 26. Returns on corporate bonds are negative, as are some key commodities tied to industrial activity.
An important caveat to the predictive power of the yield curve is that it can’t predict precisely when a recession will begin. In the past, the recession has come in as little as six months, or as long as two years after the inversion, the San Francisco Fed’s researchers note. The flattening yield curve makes banking, which is basically the business of borrowing money at short-term rates and lending it at long-term rates, less profitable. And if the yield curve inverts, it means lending money becomes a losing proposition. Either way, the fl ow of lending is likely to be curtailed. And in the United States, where borrowed money is the lifeblood of economic activity, that can slam the brakes on economic growth.