To Fear Or Not To Fear The Yield Curve

Dark forest, signifying fear

Does the U.S. Treasury yield curve always foretell a recession?

With the spread between 10-year and 2-year Treasury yields down to just 13 basis points1, an active debate is raging among economists about the efficacy of the yield curve as a recession indicator in the current cycle. Historically, an inverted yield curve is a tell-tale sign of a looming economic downturn—and markets have certainly taken note lately, with the Dow Jones Industrial Average and the S&P 500® Index both tumbling approximately 4% last week as the spread between yields sharply narrowed.

With prevailing trends pointing toward continued flattening, it’s quite possible that an inversion of the curve could occur early next year. If this happens, history tells us that the U.S. economy could be at heightened risk of a recession in late 2019 / 2020. This is a warning signal that we believe should be taken seriously. To understand why let’s delve into exactly what an inverted yield curve means.

Why economists use the curve as a leading indicator?

Conceptually, an inverted yield curve tells us that the stance of monetary policy is transitioning into restrictive territory. In very simple terms, the U.S. Federal Reserve (the Fed) controls the short (overnight) rate, and the market prices the long (10-year) rate based on its view of trend growth. Therefore, when the curve inverts, it signals the Fed has moved short rates above what the economy can sustain in the long run. With monetary policy acting as a hindrance to growth, a recession becomes more likely.

Empirically, an inverted curve has been the single best leading indicator economists have for modeling recessions. Indeed, every recession in the last 60 years was preceded by an inverted curve.2

Term spread versus term premium

You’ll note that we use the phrases slope of the yield curve and term spread interchangeably to refer to the difference between long-term and short-term Treasury yields. For example, the 10-year / 2-year term spread is currently 13 basis points (as of Dec. 7). In other words, it’s a 2.85% yield on the 10-year Treasury note minus a 2.72% yield on the 2-year Treasury note.

The bulk of the academic debate around the efficacy of the yield curve currently surrounds the notion of the term premium. It’s important to note that a term premium is distinct from a term spread. This is because Treasury yields at any tenor can be broken down into two pieces:

  1. The average expected short-term interest rate over the life of the bond (often referred to as the risk-neutral yield), plus
  2. A risk premium (or term premium) that compensates investors for the possibility that the actual path of short-term interest rates deviates from those expectations.
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Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the ...

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