The US yield curve plots Treasury securities with maturities ranging from four weeks to 30 years. When the spread between the yield on the three-month Treasury bill and that of the 10-year Treasury note slips below zero, as it did earlier this year, it points to investors accepting a lower yield for locking money up for a longer period of time.
This is unusual because long-term bonds are normally considered riskier and should pay more in terms of yield. As recession signals go, this so-called inversion in the yield curve is said to have a solid track record as a predictor of recession.
However a closer look at historical data shows that the yield curve has far from a “perfect” track record – it’s more like 50-50 – and in this case, there are several reasons to believe that this yield curve gives several false alarms before actually getting it right.
- Many “first inversions” are false alarms. A more accurate way of stating the correlation between the yield curve and recessions is to say that an inverted yield curve has predicted 10 of the last five recessions, with, however, years of advance warning. As such many previous “first warnings” have turned to be false alarms as the yield curve tended to invert and then un-invert once or twice before a recession.
- The leading indicators have not peaked yet. The spread between the 10-year treasury bond yield and the federal funds rate is just one of the 10 components of the index of Leading Economic Indicators (LEI), but the yield curve seems to get most of the press coverage among all leading indicators. The July LEI reading which came out in the last week of August showed a small increase, so it has not peaked yet. History shows that the 10 Leading Indicators taken together are far more reliable than the inverted yield curve alone. The LEI normally gives an average 15-month lead time from its peak – a peak which has not arrived yet.
- There is no sign of a recession yet. The latest economic data continues to depict a health US economy capable of growing comfortably above the 2% mark for the rest of 2019. The unemployment rate and initial jobless claims typically tick higher just ahead or in the early days of a recession, before rising sharply. Currently, the US unemployment rate is near a 50-year low. Consumer demand is a critical driver of the US economy and historically consumer confidence wanes during downturns. Yet, consumer confidence is currently near cyclical highs.
- In a globalised world, the yield curve is increasing influenced by overseas developments. With $16 trillion in negative interest rates in Europe and Japan, global investors have no choice but to invest in US Treasury bonds if they want a positive yield in hard currency. This massive rush into US dollar bonds has strengthened the dollar and pushed US interest rates artificially down. This in part explains the current shape of the yield curve.
- The Fed raised short-term rates nine times in three years, artificially creating an inverted yield curve. After seven years of very accommodative monetary policy, the Federal Reserve raised interest rates nine times between 2016 and 2018, probably going a step too far in December 2018, precipitating a near-20% market correction and slowing the economy. This move, along with the collapse of long rates due to Europe’s negative rates in 2019, created the artificial inversion of the yield curve.
Disclaimer: This article was issued by Stephen Borg, Head of Investment Management at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.