Inverted Yield Curves...So What?

I’ve been unapologetic in my critique of the Biden Administration’s fiscal response to inflation and equally critical of the Feds response by way of monetary policies. My opinion has not changed that the U.S. economy will be in full-fledged recession by the fall of 2023 and I’ve reached this conclusion by focusing on the commercial mortgage market as well as exploring recessionary signals like inverted yield curves. As I began my research for this piece, I was quite frankly shocked how little was written regarding yield curves and inversions of this economic signal. I expected more explanation and context but was fed word soup that confused me more than it helped me. I figured I wasn’t the only one that needed/wanted a clear understanding of not only the cause of the inversion of yield curves but a proper contextual understanding.

In the world of economics and finance, various indicators are closely monitored to gain insights into the state of the economy. One such indicator that has gained some attention is the inverted yield curve. We will explore how inverted yield curves typically signal an impending recession, analyzing the underlying mechanisms and historical evidence to support this correlation.

For context, “[t]he yield curve shows the interest rates that buyers of government debt demand in order to lend their money over various periods of time — whether overnight, for one month, 10 years or even 100 years… Because lending to governments in large developed economies such as the US, Germany, Japan and the UK is considered a safe bet, these borrowing rates are mostly influenced by investors’ assessment of the prospects for economic growth and inflation, and how those in turn will affect central bank interest rates.”[1]

To comprehend the significance of an inverted yield curve, it is essential to first understand yield curves themselves. A yield curve is a graphical representation of the interest rates offered by bonds of varying maturities. Typically, longer-term bonds have higher yields than shorter-term bonds due to the additional risk associated with holding investments for an extended period. Think of a Certificate of Deposit (CD) that your grandmother told you to get with your summer earnings when you were in college. If you purchased a 3-Year CD the rate of return was higher than if you purchased a 6-Month CD, you benefited from entrusting your funds with the bank for a longer period of time.

Under normal economic conditions, the yield curve has an upward-sloping shape, indicating that long-term bonds have higher yields compared to short-term bonds. This reflects the expectation that investors should be compensated with higher returns for the increased risk of holding long-term investments. The normal yield curve suggests optimism about future economic prospects, as it implies that investors anticipate higher interest rates in the future.

In contrast, an inverted yield curve occurs when short-term bond yields surpass long-term bond yields. This phenomenon is often perceived as a strong warning sign of an impending economic recession. Historically, inverted yield curves have preceded most U.S. recessions over the past several decades, making them a crucial tool for economists and market participants.

Reasons behind the Inverted Yield Curve's Recessionary Signal:

1. Expectations of Future Interest Rates: When investors anticipate a deteriorating economic outlook, they tend to shift their investments toward safer assets, such as long-term bonds, thereby increasing their demand. This increased demand for long-term bonds drives their prices higher and, in turn, lowers their yields. Consequently, the yield curve can invert as short-term bond yields rise due to the central bank's attempts to combat the economic slowdown by lowering interest rates.

2. Uncertainty and Investor Pessimism: Inverted yield curves also reflect a general sense of uncertainty and pessimism in the market. Investors' flight to safer long-term bonds is driven by concerns about the future, such as weakening consumer spending, declining business investment, or geopolitical tensions (pick one: Ukraine, China, Taiwan, Democratic Republic of Congo). This pessimism can be a self-fulfilling prophecy, as reduced investment and spending can further exacerbate the economic downturn.

The historical relationship between inverted yield curves and recessions is notable. For instance, prior to the 2008 financial crisis, an inverted yield curve appeared in 2006, signaling an imminent recession. Similar patterns were observed before the early 1990s recession, the early 2000s dot-com bubble burst, and other economic downturns.

It is important to acknowledge that while inverted yield curves have often preceded recessions, they are not infallible predictors. There have been instances of false signals, such as brief yield curve inversions that did not result in significant economic downturns. Because I have those who will end up in my DM’s talking shit about how I didn’t mention those instances when inverted yield curves did not lead to recession and hang their hat on the fact that the U.S. economy has experienced yield curve inversions without a recession I’ve listed the instances where inverted yield curves did not lead to a recession. These two instances are notable…why?

1. In 1998, the yield curve briefly inverted, with short-term rates exceeding long-term rates. However, a recession did not follow. Instead, the U.S. economy continued to expand, partly due to stimulative monetary policy and robust economic conditions at the time.

2. In the mid-1960s, there was an episode of yield curve inversion, but it was followed by a period of sustained economic growth without a recession. This occurred as the Federal Reserve pursued expansionary monetary policy to stimulate the economy.

The proportional currency in circulation in 1998 and the 1960’s pale in comparison to the amount of currency in circulation now, because of COVID related policies. Another distinction between the economic realities of 1960s and 1998 is the existence of prolonged and persistent inflation. The amount of free-flowing capital that we have in our economy coupled with persistent inflation make the current economic conditions distinguishable from the 1960s and 1998.(The reasons here require a separate blog post, stick with me).

Inverted yield curves have long been regarded as a reliable indicator of forthcoming economic recessions. The inversion occurs due to investors' expectations of future interest rates and reflects their uncertainty and pessimism about the economy's prospects. While historical evidence supports the correlation between inverted yield curves and recessions, it is crucial to consider other economic factors for a comprehensive analysis. By monitoring these indicators and understanding their implications, economists and policymakers (none of the ones currently in office) can make informed decisions to mitigate the impact of economic downturns and promote stability and growth. Typically economic recession follows 15 months after prolonged inversion, that puts us at October 2023.

[1]An inverted yield curve: why investors are watching closely by Chelsea Bruce-Lockhart, Emma Lewis, and Tommy Stubbington. Financial Times - https://ig.ft.com/the-yield-curve-explained/