traders often look at the bond market
for clues on how the US economy will
perform specifically the yield curve
Birdie back in march yes we now have an
inversion even if the yield curve
inversion happens again and happens
persistently the president tweeting up
crazy inverted yield curve so what is
the yield curve all about and why is
everybody talking about it the yield
curve is just a graph showing the
relationship between short-term and
long-term interest rates of US Treasury
notes usually the short-term rate is
lower than the long-term one but if you
are lending money to the federal
government which is essentially what
happens when you buy a Treasury note you
are taking a bigger risk by letting the
government have your money for a longer
period of time so you're going to want a
higher interest rate to compensate you
for taking on that risk but sometimes
this relationship changes if the two
rates start getting closer together
that's called a flattening yield curve
if the long-term rate dips below the
short-term rate that's what we call an
inverted yield curve and the market is
concerned about it
investors waking up this morning to a
recession warning from the bond markets
the Dow plunging more than 800 points
sparked by a key economic indicator
faltering a brutal day on Wall Street
stocks plunging as a yield curve
inverted sparking fears that a recession
could be on its way the yield curves
predictive power has made it a crucial
metric for investors and policymakers
alike the reason why we watch the yield
curve so closely is that it has been an
incredibly accurate predictor of
recessions every time that that yield
curve has inverted the economy
eventually has gone into a recession you
can see that predictive power on this
chart it shows the difference between
the long term ten-year and short term
three-month Treasury rates when that
line goes below zero it represents an
inversion and those inversions have
preceded every single US recession going
back 50 years but it wasn't until the
1980s when policymakers started to catch
on back in the late 80s the yield curve
was being referred to as a possible lead
indicator of the economy and I was asked
by my bosses whether there was anything
to this whether you could prove
statistically that there was a
relationship
Arturo Austria is one of the economists
who helped discover the predictive power
of the yield curve while working with a
colleague at the Federal Reserve Bank of
New York by early 1989 we were not only
seeing the predictive power in general
in using historical data but we actually
saw an inversion so at that point it
seemed to be indicating that there would
be a recession about a year later and
our presentations were met with a lot of
skepticism but the recession started in
1990 so it was almost a perfect
prediction many still doubted the yield
curves predictive power but astrea's
model then successfully predicted the
recession in 2001 before the dot-com
bubble burst the worst day ever on Wall
Street all the major indices are now
down for the year and perhaps most
notably after a 2006 yield curve
inversion his model accurately predicted
the 2007 downturn that became the Great
Recession Lehman here is going bankrupt
some of the biggest names in American
business are tonight gone along with a
lot of money and a lot of jobs
Australia's work focused on the
difference between the three-month and
tenure interest rates but many in the
finance world also watched the
difference between the two year and
ten-year rates closely the New York Fed
research focused on this three-month
ten-year they feel that that has the
most predictive power I think a lot of
the Wall Street guys that you talked to
will tell you that they don't start to
get excited about it until a two-year
and the ten-year inversed the broad
principles are pretty similar between
both metrics but to get a clearer idea
of how they work we can imagine traffic
on an interstate think of two and ten
year bonds like car and truck lanes on a
highway normally when the two-year rate
is lower than the ten-year traffic is
moving along smoothly cars in the two
year lane are moving faster than trucks
in the tenure but the Fed raises its
benchmark rate if they think things are
going too fast
and
imagine the Fed like the sheriff
enforcing the speed limit raising rates
puts a damper on the economy slowing
down those in the fast lane the
short-term interest rate is more closely
tied to the Federal Reserve funds rate
and it's more connected to how the
economy is expected to perform in the
short run the long-term interest rate is
usually higher investors are usually
paid more to lend for a longer period of
time as the economy grows you need the
money you lend out to be worth more when
you get it back but the long-term
outlook for the economy may not be
changing much those trucks chugging
along may even speed up a little well
you know what happens when the trucks in
the right lane are going faster than the
cars in the left lane that's the
inversion we talked about earlier and
there's a good chance there's traffic
ahead it becomes more expensive to
borrow for the short-run that in the
long run all of this affects how people
lend and the risks they're willing to
take that can help drive a recession the
unconventional traffic pattern may get
people to start changing lanes adding to
the complexity and eventual traffic it's
important to note that the recessions
don't happen immediately after the
inversion but it does mean the clock is
ticking especially when it comes to the
three-month ten-year curves that
estrella has done so much work on the
peak predictive powers for about a year
ahead you know maybe a year through a
year and a half another caveat is that
quick little inversions in the yield
curve lasting for a day a week or even
up to a month are considered exceptions
to the rule instead it's prolonged
month-to-month inversions that suggest a
recession is actually coming it's also
important to keep in mind that even a
brief yield curve inversion can spook
the markets the fact of the matter is
that we don't have the kind of markets
that we used to have we don't have
markets where it's a personal touch to
it that we have individual investors out
there doing things sometimes it's just
the urban version can get fed into the
electronic trading systems and it can
just trigger really fast knee-jerk
reactions a lot of this is program
trading just computerized trading
especially when you have markets to
trade on thin volume it doesn't take a
whole lot to move them
and when something that has the
predictive power of an inverted yield
curve comes along it can be very
influential in a highly sensitive market
so let's say the yield curve has
actually inverted what happens between
that moment and the theoretical
recession that the inversion is
predicting well a back-and-forth tends
to emerge from market watchers and the
inversion in 2019 offered a good example
with one camp essentially saying this
time it's different it's always kind of
a scary thing to say this time is
different but I'm gonna say it too
the yield curve inversion I would not
read too much into there's no likelihood
that the inversion of the yield curve
that's occurring in this period a is
similar to the ones that occurred in the
prior period or be that it will lead to
a recession and another camp heating the
curves warnings I've been getting this
Bush bag that essentially a curve is
inverted because global yields are low
so you know it's it's not that good an
indicator I would actually argue it is a
very good indicator because we just find
it very hard to see how global growth
can be this weak and the u.s. can be
this one island of of essentially
prosperity I think we're up toward 40
percent of recession risk within the
next 12 months and that's a large part
in reflecting what the yield curve is
telling us amongst the curves detractors
some wondered if the very act of
watching the curve so closely had
undermined its worth as an economic
indicator historically we had not been
following the yield curve as closely as
we follow it now there's something
called the Heisenberg uncertainty
principle something that's being
observed is going to act differently
than when it's not being observed others
pointed to negative sovereign interest
rates abroad you have 20% more
sovereigns yielding negatively than you
had just a few months ago so there's
this drive for yield attributing the
inversion to a spike in demand for
long-term US Treasuries as money fled
those negative rates in other countries
it's just it's just a reflection of the
fact that everybody wants our debt
questions also emerged over whether
Federal Reserve policy since 2008 played
a role I think the Fed still has a large
balance sheet and that could be putting
some downward pressure on those
longer-term rates
I'll keep watching that carefully for
sure but I don't yet see the signal that
suggests it's time to get worried about
a downturn or whether the trade war had
contributed I think what's happening is
the trade tensions are catching up with
the market and I think people realize
it's slowing global growth and this
uncertainty does raise the risk of
recession to its highest level since the
2008 debacle and I think that's really
what's going on here amidst this back
and forth something interesting happened
the yield curve suddenly uninvited does
that mean the recession fears were
overblown and the naysayers right not
necessarily
whenever the yield curve on invert sorry
steep ends people tend to be happier
more optimistic if an inversion is a
negative sign then necessarily a nun
version it would be a positive sign and
that may make intuitive sense but what
you'll see is if you look at a graph of
inversions and recessions lagging
thereafter you'll curve typically
uninviting begins you'll have this
inversion with short-term rates
exceeding long-term rates and then it's
not uncommon to see that correct itself
even in the span between the initial
inversion and the recession in other
words this Reese deepening has proven
part of the yield curves normal
predictive behavior so the inversion is
really just the beginning of the
recession warning but the curve can do
all sorts of things as the recession it
predicts comes about at least
historically but looking ahead the
economy's immense complexity could
easily surprise experts with deviations
from this pattern it is one indicator it
has been a very good indicator is it
going to be a foolproof indicator only
times gonna be able to tell that