The Inverted Yield Curve

So what exactly is an inverted yield curve and does it really matter? Historically, when long-term interest rates fall below short term rates, more often than not, recessions ensue. However, more recently the results have been mixed.

Back in February of 2005 Allen Greenspan, then Fed Chair, debunked the theory that an inverted yield curve signaled an economic slowdown, calling it a “misconception.”  He said, “the quality of that signal has been declining in the last decade, in fact, quite measurably.” 

The thinking is that when interest rates, ten years or longer fall, investors believe the long-term economic outlook is poor and that demand for capital will be low. Rates or the price of capital will fall.

Several factors of the last few years have served to cloud the effectiveness of the inverted yield curve as an effective predictor of recessions. One of the more significant is that the Federal Reserve has bought up a huge amount of long-term Treasurys during the Great Recession, increasing demand and hence, driving long term rates lower than markets alone would have done.

Another is that foreign investors are increasingly buying US Treasurys as a safe haven against their own countries’ falling economies and currencies. With Europe and China in decline, the US economy stands out as a safe place to invest in risk-free Treasurys of all maturities. And finally, the inversion needs to run for a longer period of time than a day or two.

A typical yield curve is a graph of an upwardly sloping line connecting bond yields or interest paid generally on US Treasurys. The chart below shows the current yield curve is almost flat, as the spread between the 2-year and the 10-year is only 0.01%.

A year ago, there was a 0.22% spread, still a relatively narrow spread by historical measures. Since 1956, recessions have started, on average, 15 months after the yield curve inverted.

A yield curve is deemed normal when long-term yields, in this case 10-year yields are substantially higher than short-term yields, largely because long-term bond buyers demand a return premium in yield to protect against the possibility of inflation that typically occurs when an economy heats up.

Today we see many buyers for long-term bonds which drives down their interest rates. Think about it this way; when many people want to lend money to you, (ie. bond buyers and savers) you don’t have to pay rates as high as when few people want to lend to you.

It can be argued that supply and demand – today’s exceedingly high demand for Treasurys in a tight market (because the government bought up so many of them years ago) – better explains the inversion than fear of an economic slowdown.

You will also notice in the chart above that two-year rates are almost a full percent lower now than they were a year ago. That fact can be explained by the economy, which was growing at as much as 4% then, and is closer to 3% now. We also have a Federal Reserve actively reducing rates to sustain economic growth and avoid recession. Lower short-term rates enable businesses to access inexpensive capital, thereby boosting profits.

Can the US economy weather the headwinds of a slowing global economy, trade-impeding tariffs, and a press seemingly determined to realize the warnings? So far, the economic data; including Purchasing Managers’ Index, Leading Indicators, Consumer Confidence, and Jobless Claims are all positive this week.