Can An Inverted Yield Curve Cause A Recession?

from the St Louis Fed

-- this post authored by David Wheelock, Group Vice President and Deputy Director of Research

An inverted yield curve - or a situation in which market yields on shorter-term U.S. Treasury securities exceed those on longer-term securities - has been a remarkably consistent predictor of economic recessions. However, simply because inversions forecast recessions does not necessarily mean that inversions cause recessions. Why might a yield curve inversion cause economic activity to slow?

Banking and Yield Curve Inversions

One possible channel is through the banking system. Banks engage in maturity transformation. That is, on average, the loans in a typical bank’s portfolio have a longer term to maturity than the deposits and other funds they use to finance those loans. In essence, banks transform their short-term liabilities (such as deposits) into longer-term assets (such as business and consumer loans).

Normally, banks can profit on the spread between the yields on longer-term assets and the interest they pay on deposits and other short-term liabilities. However, bank profits get squeezed when short-term interest rates rise relative to the yields on long-term assets. This can lead banks to cut back on their lending, which, in turn, can put the brakes on economic activity.

Tightening Lending Standards

Recently, the Federal Reserve asked banks how their lending policies might change in response to a hypothetical moderate inversion of the yield curve.1 Many of those surveyed indicated that they would tighten lending standards or price terms on every major loan category.

When asked why they would do so, several potential reasons were given:

  • An inversion could cause loans to be less profitable relative to the bank’s cost of funds.
  • An inversion would cause their banks to be less risk tolerant.
  • An inversion may signal a less favorable or more uncertain economic outlook.
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Disclaimer: Views expressed are not necessarily those of the Federal Reserve Bank of St. Louis or of the Federal Reserve System.

No content is to be construed as investment advise and all ...

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