When a recession may be imminent, analysts tend to look at the yield curve for signs. An often-heard term is the yield curve inversion. Normally, we would of course expect long-term bonds to have higher yields than short-term bonds. That is, the interest received per year should be higher for long-term bonds under normal circumstances. However, a combination of the Federal Reserve raising interest rates and traders buying long-term bonds can lead to an inversion of the yield curve. This is what we see happening this week.
Data obtained from www.treasury.gov
As can be seen in the graph above, the 10-year yield is lower than the 3, 6, and 12-month yield. Predicting recessions using the yield curve is a matter of correlation. In recent history, there has always been an inversion of the yield curve before a recession. This still cannot guarantee that an inversion of the curve means an upcoming recession. Furthermore, even when the curve does work to predict an upcoming recession, the delay between such an inversion and a recession could be several years. It is also important to note that the 10-year yield is still higher than the 2 and 5-year yield, so that there is no inversion there.
The likely reason for the change in the yield curve this time around is the decision of the US central bank (Federal Reserve) not to raise interest rates further in 2019. Investors may take this as a sign that the Fed expects an economics downturn. The result of this is that equity tends to be sold and investors opt for long-term bonds instead. As demand for long-term bonds rises and prices increase, the yield on these long-term Treasuries falls.
All this doesn’t necessarily have to mean that a recession is coming in the near future. CNBC reported that the Chicago Fed president Charles Evans said US fundamentals, such as the job market, still show positive signs and that there is no unusually high risk of a coming recession. This would indicate that traders may have overreacted to the Fed’s signal last week.
All in all, we should probably not be too quick to jump to conclusions on the basis of the yield curve alone. Especially not just based on the difference between very short-term bonds and the 10-year yield. Although there is still uncertainty on the global scale, including trade tensions between the US and China, we shouldn’t forget that the numbers indicate a strong US economy. Thus, worries about a coming US recession seem to be premature at this moment.
Written by Hazel Alberts