Yesterday’s Perfect Recession Warning May Be Failing You

Recently, Wall Street and the Financial Media have brought much attention to the flattening and possible inversion of the U.S. Treasury yield curve. Given the fact that an inversion of the 2s/10s Treasury yield curve has predicted every recession over the last forty years, it is no wonder that the topic grows in stature as the difference between the 2-year Treasury yield and the 10-year Treasury yield approaches zero. Unfortunately, much of the discussion on the yield curve seems to over-emphasize whether or not the slope of the curve will invert.  Waiting on this arbitrary event may cause investors to miss a very important recession signal.

The Incentive to Lend

A friend approaches you and asks for a loan. You are presented two options, lend her money for two years at 2% annually or for ten years at the same 2% annual rate.

Later that day, another friend approaches you for a loan. This time you have the option of lending money for two years at 2% or for ten years at 6% annually.

For the lender/investor in both cases, we will ignore inflation risk and assume the two borrowers are in similar financial circumstances. Given the options, you likely answered that if you were forced to lend in example one, it would be only for two years as lending for ten years produced no additional financial incentive to compensate for the additional eight years of risk. Keep in mind most of us would not lend for two years either due to the low-interest rate.

In example two, you may have been incentivized by the higher ten-year interest rate the borrower was willing to pay you. In example one, the “yield curve” is flat at 2%. In example two it is considerably steeper as 10-year “yields” are 4% higher than 2-year yields.

As portrayed, when investors are faced with a flat or inverted yield curve, their incentive to lend for longer terms is greatly diminished. The opposite holds when the yield curve is steeper as in the second example. Taking this one step further, when the absolute level of yields is very low, the incentive to lend, irrespective of the slope of the curve, is also greatly diminished.

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