Through all the Russia hysteria and obsession with everything Donald Trump, the noise on another issue continues to grow with momentum in the financial press. Because the topic implies a negative outcome, I’m expecting it soon will boil over into the mainstream press as well. The subject is called the inverted yield curve.
I struggle with writing about this topic in the column, because by its very nature it’s a bit geeky. At the same time, however, if readers are hearing about the yield curve in the headlines, its better to have at least some frame of reference to evaluate the information.
An inverted yield curve occurs when rates on short term bonds become higher than rates on longer term bonds. Based on pure logic the longer the maturity on a bond, the higher the interest rate, as long-term bond investors are giving up their capital for a longer period. The two focal points to observe the inversion phenomenon are typically the two-year U.S. Treasury note and the 10-year U.S. Treasury bond.
According to data from the Federal Reserve, over the past 30 years or so, the 10-year bond has provided a yield about 1 percent to 2 percent higher than the yield paid on a two-year note. The difference between the two is called the spread. As I write this column the spread is current 0.26 percent. A spread at this low a level means the yield curve is pretty much flat. What tends to come next is likely to be an inversion.
The reason this may become a headline grabbing topic soon is that over the past 30 years an inverted yield curve has been one of the most reliable indicators of an imminent economic recession.
Both the 2001 recession and the 2008 recession were preceded by a yield curve inversion, and the recession of the early 1990s experienced a preceding flat yield curve.
It's important to understand, the inverted yield curve does not cause a recession. Instead, the inversion is better described as a gauge of investor expectations regarding future growth in the economy, and so in using this metric as a recession indicator we are assuming that real investors, with real money on the line, are collectively able to sense the onset of a recession.
This topic is geeky (you were warned), and rather than getting too deeply into the weeds on the technicalities of an inversion, I think it’s better to discuss how to use this news if, and when, on inversion comes.
It is true this financial indicator has been very reliable in predicting past recessions. A critical difference right now, however, is that interest rates around the globe have been stuck at abnormally low levels for 10 years. As this atypical low interest rate environment corrects itself — and I believe it will correct over the next few years — there are bound to be strange dislocations and situations which have no reliable frame of reference. This may be one of them.
Currently, growth in the U.S. is gaining steam. Unemployment is at historical lows and the labor market is very healthy. Inflation is starting to emerge (a good thing), and corporate earnings can only be described as extremely strong. With not one other collaborating indicator, it’s hard to make an imminent recession call.
That being said, if the curve inverts I will be paying attention. While this time the inversion may be a false alarm (it has happened before), prudence requires that we pay extra attention if this phenomenon does occur.