Signs of the Times: A Cautionary Tale About Yield Curves

The stock market is in a panic selling frenzy following news that the US Treasury yield curve has inverted. But why is that so scary? Can a simple line on a graph be such a powerful ominous portend of financial doom?

A yield curve normally has an upward trending shape with the shorter term bond yields being below that of the longer term. This is in keeping with the Liquidity Preference Theory which states that investors expect a higher return on securities with long term maturities (such as the 30 year US Treasury bonds) because of the greater risk they carry being held for such a long period. Investors prefer more liquid, shorter term holdings which carry less risk and thus they will accept a lower yield for short term bonds.

The inversion of the Treasury yield curve means that the yields on the shorter term bonds are now higher than that of the longer term bonds, which is an abnormal, and somewhat unsettling, situation. At face value, it makes almost zero economic sense to be getting more interest for a short term investment than a longer, less liquid one. Currently, yields on the benchmark 10 year Treasuries are less than the 2 year Treasury yields.

When a yield curve inverts, it's because investors have lost confidence in the near-term economy. They demand more yield for a short-term investment than for a long-term one because they perceive the near term to be riskier than the far distant and hopeful future. As a safety net, they would prefer to buy long-term bonds and tie up their money for years even though they receive lower yields. Investors would only do this if they think the economy is getting worse in the near-term.

So what do yield curve inversions have to do with recessions? Is there any solid backing behind the plaintive whines of financial analysts who claim that the inverted yield curve is warning us all of impending doom?

Like the ocean water receding before a big tsunami, an inverted yield curve is in interpreted as a reliable sign that usually precedes a recession, although the reasoning behind this may not be so straightforward.

It’s a bit of a chicken and egg situation because one of the reason inversions happen in the first place is because investors are selling stocks and shifting their money into bonds as they believe there might be an economic recession looming, and they prefer to accept the limited returns offered by bonds than the potentially huge losses they could incur by holding onto stocks into a recession. So demand for bonds goes up and the yields they pay go down. On the other hand, the inverted yield curve is interpreted as a forecast of a recession approaching within the next two years, so on inversion investors usually start selling off their stocks. So what came first, recessionary fears or an inverted yield curve?

One thing’s for sure, inverted yield curves have proceeded every recession since 1956. The last inversion began in December 2005 and heralded the Great Recession, which officially began in December 2007. Then came the 2008 global financial crisis. There was also an inversion before the tech bubble burst in 2001. That’s why a little curve inverting is so daunting for financial markets.

However, times have changed since the last financial crisis, and so too have monetary policy responses. Through quantitative easing and dovish monetary policy, interest rates and bond yields have been low all through the recovery and expansion that followed, and they’re low still. This is the new normal. Besides, stranger things have happened in the bond markets, like the rising amount of negative-yielding debt across the globe. Underlying economic fundamentals, like the US unemployment rate, still remain strong. So proceed with caution, not panic.