US: The Self-Fulfilling Threat Of An Inverted Yield Curve

Yield curve underlines recession fears

On the economics dashboard of doom, we have another flashing warning light. Overnight we have seen the inversion of the 2-10 year part of the Treasury yield curve, the first time this has happened since 2007 when the global financial crisis started to bite. Moreover, an inverted yield curve preceded all nine of the US recessions since the mid-1950s so it is understandable why economists are getting a little nervous.

In normal times investors want to be compensated for the risk of lending for longer periods of time – you do not know what may happen over the next ten years (will inflation spike, will a country get into debt problems, etc) – and they feel more comfortable lending over a shorter period of time. Hence why interest rates on 2-year debt are normally lower than 10-year borrowing costs. However, the fact that this has flipped suggests that investors are seriously worried about a downturn, which will keep inflation low. The market is also hinting that it thinks the Federal Reserve is “behind the curve” and that it may not cut short-term interest rates quickly enough to head off a recession.

The 2-10 year yield curve and GDP growth

(Click on image to enlarge)

Source: Macrobond, ING

Is it different this time? Probably...

Now it is important to point out that an inverted yield curve has given false signals in the past on possible US recessions (around the Russia/LTCM crisis in 1998 for example), while other countries have experienced prolonged yield curve inversion in the past without recession – the UK for example through much of the 1990s. As such it is important to emphasize the obvious point there is no inevitability of recession.

Then there is always the argument that “things are different this time” and there is certainly a strong case that can offer some comfort. The lagged effects of the Fed’s quantitative easing program has made the curve flatter than it otherwise would be (relative to previous cycles). After all, the trillions they invested in the Treasury market were to stimulate the economy by driving down borrowing costs through the economy, boost liquidity and make higher-risk assets look more attractive.

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