If you follow the markets, you probably know that the yield curve has been partially inverted. You also know for…
If you follow the markets, you probably know that the yield curve has been partially inverted. You also know for sure that this is quite a big deal, because almost every financial reporter in the country continues to say so. It may be less obvious why, exactly, everyone has freaked out about this.
The answer is in a word recession. Odds are good that you could suffer.
Here’s what’s going on.
The yield curve compares the return on different bonds with the same credit quality over time. It charts otherwise identical bonds against their different maturities to report the return on the investment in the short term vs. in the medium or long term.
For example, if a two-year AAA bond paid 1
% and a five-year AAA bond paid 1.5%, they could present a yield curve of 0.5.
The curve compares the same credit quality, because when the bonds are identical, the only one that varies their return over time.
You can build a return curve of any set of bonds, but the most common reference value is the graph comparing the return on three-year, two-year, five-year, 10-year and 30-year US government bonds. This is what economists refer to when they discuss the “return curve.”
This is because US sovereign debt is a critical indicator. Banks (and even some governments) use it as a universal value store. It is the safest place to put your money on, despite the fact that the latest political turbulence is surely assured of a return on investment.
Treasury rates move in reverse to investors’ confidence. When banks and investors feel good for the US economy, interest rates rise. They feel convinced to put their money in other sectors like mortgages and corporate loans, so tax vouchers have to pay more interest in competing. But when confidence decreases, investors are more likely to seek a safe place for their money. Treasury bonds provide a unique form of collateral, so their return is down.
Okay, so now you know what a return curve is and why are we carefully following Treasury prices.  Now what’s the big deal about “inversion”?
Typically, the yield curve follows a predictable rate where long-term bonds outperform short-term bonds. Basically, the government pays more to lend money for a long time. This is known as a “positive” return curve, since the difference between a long-term return and a short-term one is positive.
But sometimes short-term bonds will yield more than the long-term thermal. The curve becomes negative. This is what is called an “inverted” return curve.
That was what happened on Monday. Both two-year bonds and three-year bonds began to pay more than five-year bonds. Ten-year bonds are also on their way, which are the most targeted markets – periods when the two-year fund gives more than the 10-year-old.
This means that demand for long-term bonds exceeds demand for short-term instruments. Investors have begun to prioritize long-term collateral over access to capital. They worry more about losing their money than they’re missing out on an opportunity.
This does not happen often. In fact, historically, only in very specific situations: shortly before the beginning of a recession. The yield curve was negative in relation to two-year vs. five-year and two-year versus three-year state tax in 2005/2006, 2000, 1988 and 1978, shrinkage of recessions. The only exception was 1998, when the yield curve was attenuated very short for a month or two in the summer but did not lead to a recession.
Therefore, the economists consider the return curve to be a reliable bellwether for future recessions. This does not mean that the market will collapse immediately. Usually inversion precedes a recession with one or two years. So if historical patterns are true, the economy will turn around by the end of 2019 or 2020.
It is important to note that this is a correlation, not a causal link. Bond prices do not drive a recession. They only show how the bankers are looking at the market. (See, in fact, our own Katherine Ross for why you may not panic yet.)
An inverse of the return curve would usually suffice to freak economists out themselves. In this case, the yield curve will connect to some other red flags.
For several years, economists have warned of another recession, if nothing but what we simply depend on. Recessions tend to happen every 8-10 years or so and the last one met in December 2007.
Stock prices have also created a lot of anxiety. When Dow Jones Industrial Average has increased in recent years, many market researchers have warned for potential overvaluation. Basically, investors have become overly enthusiastic and pay more than the underlying assets are worth. When that happens, the market will eventually correct.
What do you know? The stock market is in a thousand plus points after several losses earlier this year. On Tuesday, the dollar took a blow to most major currencies. Oil prices, which have risen before each US recession since the Second World War, spent most of 2018. The market for the crypto market, while relatively small, has collapsed by 85% in the past 12 months and wiped out more than $ 630 billion in value. Layoff messages have already begun, especially in the automotive industry.
Even economists have long warned for the current administration’s policy. The black trade war like Donald Trump began with most American trading partners has shaken investors and industries. Despite the government’s efforts to alleviate the pain of higher prices, nuclear sectors such as agriculture and manufacturing indicate that operations have slowed down, and General Motors (GM) personnel have confirmed that the company’s redundancies were due to bullet-driven steel prices.
There may be many tools in the box if and when this recession hits.
In recent years, the government has burned through the resources it would usually use to combat a recession. Interest rates have risen under historical terms since 2008. The Federal Reserve is usually responding to a decline by lowering tax rates as an incentive for lending, but at the moment there is not much for cutting.
Government stimulus expenses would be limited by the 21 billion national debt. While the textbook’s economy recommends that the Congress buy and rent to support the private market during a recession, this would be political and perhaps financially difficult.
Tax savings, another go-to, have already been burned up. The decline in December created which economists called “sugar high”, essentially a spur of consumer spending in an already growing economy. With this legislation’s $ 2.3 trillion paper and, again, high public debt, another tax cut would be difficult and, depending on their beneficiaries, it could simply flood already liquid markets with unnecessary capital.
This, more than anything, is the most important issue that politicians will face. If a recession strikes, the government can not have many resources to buy, rent or lend when we need it most.
(This article has been corrected.)