Introduction
In the orchestra of global finance, the yield curve plays a crucial note—a note that, when inverted, transforms the symphony into a discordant tragedy. As economic conductors strive to harmonise growth and stability, the inversion of this note signals impending dissonance.
Dramatic metaphors to musical nuances aside, a yield curve and its inversion is an accepted omen amongst investors and one of the telltale signs of a forthcoming recession. Before understanding this supposed philosopher’s stone of economic stability, we must comprehensively understand bonds and their yields.
A bond is a sum of money that an investor lends to a company or a government with the agreement of repayment over time with interest. This interest, earned by an investor annually, per $100 is their yield (to be precise, current yield). A bond yield can then be defined as the interest payment on the bond as a percentage of its price. For example, if a bond trades at $1000 and carries an interest of $60 annually, its bond yield is 6%. The bond price and the yield they generate are inversely related, and that’s where the curve comes in.
The Yield Curve measures the yield of all the bonds that the Treasury is selling over a long period. The maturities of the bonds are plotted on the X-axis and the yield they generate on the Y-axis. A regular-shaped yield curve is upward-sloping, meaning that longer-term bonds pay investors higher returns; this may be justified by the Liquidity Premium Theory, which indicates that longer-term bonds pose a higher risk to the investors than shorter-term bonds as they hold your money for a longer period over which a negative event may impact the value of your bond or a more attractive investment may arrive. When investors believe that the economy is heading towards a rough patch, they remove their money from short-term investments such as stocks and place it into safer investments like long-term bonds, increasing bond prices and lowering yields. Thus, when short-term interest rates go up, and investor sentiment goes down, the yield curve flattens and can eventually inverse.
Historical Significance and Present Predicaments
Now, the yield curve makes for a simple phenomenon to understand, making the buzz around it seem unjustified, but history seems to back up the predictive power of the yield curve.
As we can see in the given graph, every time the curve has dipped below zero, a recession has followed. The last five American economic recessions were preceded by the inversion of this curve, making us wonder if it is grounded in coincidence or causation.
Here’s how the yield curve looked like in October 2023-
The yield for a ten-year U.S. government bond was 4.71 per cent, and for a two-year bond - 5.09 per cent, representing an inverted yield curve; this meant investors were getting paid more to hold short-term government debt than long-term debt. Several factors contributed to this unusual inversion of the curve.
The Federal Reserve has been raising interest rates rapidly to fight inflation, pushing up yields on short-term securities sensitive to Fed policy changes. At the same time, worries about a potential recession make long-term bonds more attractive to investors seeking safe returns, squeezing 10-year and 30-year yields downward.
Apart from the market’s technical factors and lower long-term growth expectations, two factors mainly contribute to the inverted yield curve: investor concern about an economic downturn, which boosts demand for long-term treasuries, and the Fed’s aggressive policy response to 40-year high inflation, pushing up short-term rates.
Equity markets have always reacted negatively to the inversion, with top indices falling over 10% from recent peaks. The inverted curve also reflects a flight to quality, with investors moving towards safe assets like treasuries and away from riskier securities.
On average, a recession has followed an inversion 14 months later. The curve has offered a reliable warning of trouble ahead. However, the timing between inversion and recession varies from case to case.
Beyond yield curve inversion, indicators like unemployment, GDP growth, manufacturing activity, and inflation expectations can gauge recession likelihood. U.S. unemployment remains low at 3.7% as of January 2024, indicating continued economic health. However, ongoing supply chain disruption and mixed manufacturing and services data paint a muddy picture. While the inverted curve warns of a likely downturn, its timing and severity depend on how these other economic measures evolve.
To address the warning signal of recession, the Fed could slow its pace of rate hikes or even cut rates. However, with inflation still extremely elevated, the Fed is unlikely to pivot on rates until price stability returns. To avoid stoking inflation expectations, the Fed may not respond to the yield curve inversion in isolation.
While timing a recession’s onset is difficult, prudent preparation remains wise. As warning signs of a recession multiply, individuals should also evaluate their finances and make defensive adjustments. To prepare for income loss, households can pay down debts, increase savings, and postpone major purchases. During downturns, to offset stock market declines, investors can diversify investments away from volatile equities.
While further yield curve flattening is possible, the gap in 2 and 10-year yields likely cannot exceed 1.2% before inducing a recession. If a recession hits, the Fed would likely cut rates, boosting prices for medium-duration notes.
The flat or inverted curve suggests investors may be best served laddering maturities at the short-end of the curve to capitalise on yield inversion rather than extend in long bonds. Remaining cautious and nimble is prudent, given recession probabilities in the next couple of years.
Conclusion
In conclusion, while the inverted yield curve is a reliable indicator a recession may be on the horizon, it should not be viewed in isolation. The global economic landscape is ever-evolving, and various factors contribute to market dynamics. Prudent financial planning, awareness of economic indicators, and flexibility in investment strategies are essential components for individuals navigating the uncertainties associated with an inverted yield curve and its potential implications for the broader economy.
By Riddhi D. Sharma