An inverted yield curve is an interest rate environment through which longer-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is considered to be a predictor of economic recession.

In fact, at the end of last week, the three-month Treasury bills yield rose above the yield for 10-year Treasuries for the first time since 2007, signifying warnings that the US might be heading towards a recession later this year or in early 2020.

Before going through the dynamics of how the latter might influence the overall economy, it is key to identify and explain essential concepts circulating within the concept of the yield curve:

• What are treasuries?

US Treasuries are bonds sold by the federal government, most of which pay a fixed rate of interest over a fixed period, ranging from one month to 30 years. They are considered the world’s safest securities because they are backed by the full faith and credit of the US government.

• What are treasury yields?

Treasury yields are a measure of the annualised return an investor can expect to receive for holding a government bond to maturity. They also serve as a proxy for interest rates. Yields are determined by the bond’s price relative to its stated interest rate. When bond prices rise, yields fall.

• Why are inverted yield curves unusual?

When a yield curve inverts, it's because investors have little confidence in the near-term economy. This typically occurs when investors prefer to buy long-term bonds and tie up their money for longer periods even though they receive lower yields. This is most likely to occur if the economy is slowing sharply and faces a meaningful risk of recession.

However, although yield curve inversions have historically paved the way for major economic slowdowns, some factions of the market are interpreting the aforementioned yield curve inversion to be an exception to this rule given the signals from other economic indicators.

Although increased pessimism and concerns in relation to growth persist, it is key to take note that a solid labour market continues to underpin consumption, the latter being regarded to be the most important driver of US economic activity.

The addition of more workers into the work force has contributed towards an expanding productive capacity and an increased income generation.

Apart from consumption, rising business investment is another important aspect which is also regarded to be a key driver of US growth. Moreover, while the effects of the tax cuts are diminishing, these are being offset by higher levels of government spending.

Additionally, following the continuous sharp decline in European government bonds, this inevitably puts downward pressure on US yields given global interconnected markets and investment flows. Last week, Germany’s 10-year Bund has drifted into negative territory for the first time in three years.

In line with the above mentioned arguments, this yield curve inversion is unlikely to be the traditional signal of a US recession. This should however motivate policy makers to come up with the necessary measures to enhance the economy’s overall growth. Such measures may include infrastructure modernisation as a means of reducing the risk of self-fulfilling expectations operating through the financial asset channel.

The misinterpretation of the current inverted yield curve might have negative consequences on the overall economy. Such misinterpretation might cause stocks to fall, volatility to increase while simultaneously increasing the risk of market illiquidity. All these factors may eventually dampen household and business confidence, postpone business decisions, thus putting increased pressure on economic growth.

Disclaimer: This article was issued by Andrew Fenech, Research Analyst 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.

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