The Inverted Yield Curve of March 2019

Frank Yozwiak

Key Conclusions:

  • Part of the U.S. Treasury yield curve inverted in March of 2019
  • An inverted yield curve may be correlated to a recession – correlation is not causation
  • Yield curve inversions do not predict the severity or length of recessions

 

Perhaps you’ve already heard the news: On Friday, March 22, 2019, the yield curve inverted (cue the Law and Order “Chung Chung” sound effect).  The yield on the U.S. Treasury 10-year dipped below the yield on the U.S. Treasury 3-month for the first time since 2007.  In such a time as this, it is only natural that you may have some questions such as: What is a yield curve and what is an ‘inverted’ yield curve?  What can cause the yield curve to invert?  Why is it a big deal that the yield curve inverted? Does this mean a recession is coming?  Hang with me for the rest of this article and we will explore these questions together.

 

What is a yield curve and what is an “inverted” yield curve?

 

Bond yield is the return an investor realizes on a bond.  Mathematically, a bond’s Current Yield = Annual Interest / Current Price.  A yield curve is a graph that plots the yield rate on bonds of equal quality over a range of maturities.   If you hear people on TV or the radio talking about THE yield curve, they’re talking about the one comparing the yield on U.S. Treasury bills, notes, and bonds ranging from short-term (one month) to long-term (30-years).  Horizontally along the X axis is the maturity, or the length of time until the bond will be repaid.  Vertically along the Y axis is the yield expressed as a percentage.

Normally, shorter-term bonds have lower yields than longer-term bonds.  This is shown as an upward slope on the graph (see the orange line in the chart to the right, representing the yield curve of March 2018).  This makes intuitive sense because as investors, the longer we tie up our money in bonds, the greater the risk of inflation or default, so we would expect to receive a higher rate of return.  Sometimes, such as in March of 2019, the yield curve “inverts” – meaning some of the shorter-term bonds have higher yields than some of the longer-term bonds – causing at least a partial downward slope (see blue line in the chart to the right, representing the yield curve of March 2019).

 

It is important to note that when you have ten data points along the X axis (1-month, 3-month, 1-year, 2-year, 3-year, 5-year, 7-year, 10-year, 20-year, and 30-year), there can be multiple different kinds of inversions, and the whole curve is not necessarily always sloping in the same direction.  Take another look at the chart above: part of the blue line is sloping down while another part is sloping up.  In fact, the 2-year yield is still lower than the 10-year yield – more on that later.

 

What can cause the yield curve to invert?

 

There are [insert big number here] things that can cause a yield curve to invert.  I will briefly touch on a couple potential inversion causes, but by no means is this meant to be a comprehensive list or what I think may have caused this most recent inversion.

 

One potential cause of a yield curve inversion is speculation combined with supply and demand.  Consider this hypothetical situation: if bond investors think the economy may be slowing within the next 1-3-5 years, they may be more willing to tie up their money in longer-term bonds to lock in the higher yields today.  Why? One reason is to avoid having to reinvest at lower rates when shorter-term bonds come due during the potential slowdown.  The thought is that if a slowdown really does come, the Fed would lower rates for a while to help speed the economy up again.  So, if those shorter-term bonds mature at that time and you want to reinvest the proceeds, you might not be able to get as high a rate on new bonds then as you can today.

 

As more and more bond investors start going for the longer-term bonds, demand increases which drives up their prices on the open markets.  Yield and bond prices have an inverse relationship: as bond prices increase, the relative yields of those bonds decrease (if we both buy the same kind of bond that has the same annual interest rate, but I pay a higher price for my bond than you did, your bond has a higher yield).  At the same time on the flip-side, as the demand for shorter-term bonds decreases, which lowers their prices on the open markets, their yields increase.  Result: yield curve inversion.

 

Note that yield is not the same thing as the interest rate.  Interest rates and market prices for bonds have an inverse relationship: as interest rates decrease, market prices for existing bonds with higher rates increase (if you buy a bond today and the Fed lowers rates tomorrow, the bond you bought with the higher rate has become more valuable).  So, in a similar vein as the thought above (i.e., speculation of a market slowdown…the Fed will probably lower rates), this adds to the demand for longer-term bonds.  Result: yield curve inversion.

 

Quantitative Easing and Unwinding the Fed’s Balance Sheet

 

One other potential cause for a yield curve inversion is the Fed unwinding its balance sheet.  This topic got its own sub-heading because it alone could be written about and discussed for days, but it’s worth briefly touching on here.  To help with the recovery after the Great Recession that began in 2007-08, the Fed undertook a strategy called quantitative easing.  In very general terms, it’s a policy where the Fed purchased securities from the open markets, around $3.7 trillion worth, increasing the money supply in an attempt to increase lending and stimulate economic activity.  Fast forward to today, the recovery has been going strong for nearly a decade, and the Fed is trying to figure out how to get all those securities it has been holding and reinvesting off its books.

 

This reversal of the quantitative easing policy, or unwinding the Fed’s balance sheet, has been dubbed “The Great Experiment” – because this whole strategy has never been tried before.  This part involves the Fed releasing back into the wild, if you will, a massive quantity (upwards of $50 billion per month) of securities, of which an estimated 60% is U.S. Treasury bonds.  “So, effectively we’re increasing the supply on the market of U.S. Treasuries…We’re letting the supply of U.S. Treasuries in the hands of the private sector grow,” says St. Louis Fed Research Director Chris Waller.

 

As it happens, the average maturity of the Fed’s current Treasury holdings is eight years, so any action the Fed takes with respect to its balance sheet effects the mid- long-term part of the yield curve (i.e., 10-year yield).  In theory, the increase in supply would decrease the price, and thus increase the bond yields.  However, the Fed can be flexible in this unwinding.  If the Fed slows or stops this unwinding process, and instead reverts to reinvesting proceeds from its maturing bonds into new bonds as it had been doing all along, it could push the 10-year yields down further.  Result: Yield curve inversion.

 

Why is it a big deal that the yield curve inverted?

 

In short, an inverted yield curve has become known as a relatively reliable predictor of a recession.

As we saw on the chart above, with ten different maturity lengths to compare, there are more than a few different combinations of yields to compare.  Of all the possible comparisons, the 2-year/10-year yield inversion is generally talked about as the “most reliable” predictor of a recession because (to date) it has always been correct. This is not the kind of inversion we saw in March, that was a 3-month/10-year inversion.

 

Side Note: A “recession” is defined as two consecutive quarters of negative economic growth.  So, it’s technically possible to have a 6-month recession.  Recency bias has us remembering the most recent recession that began in 2007-08, but we might forget that not all recessions are created equal.  In fact, since the end of WWII, there have been ten other recessions (not including 07-08).  In several measurable ways, the 07-08 recession was the worst.  Those other ten recessions ranged in length from 6 to 16 months – the 07-08 recession lasted 18 months.  Further, in terms of decline in economic activity, the 07-08 recession was the deepest in the post-WWII era.  What’s the point? Even if a recession is coming, it doesn’t necessarily mean it’s going to be another 07-08.

 

Back to the 3-month/10-year inversion that did occur: this inversion has happened three other times since the mid-1980s and yes, after each of those three inversions a recession has followed.  However, this does not necessarily mean a recession is guaranteed.  Yes, there appears to be a correlation between certain yield curve inversions and recessions, but correlation is not causation.  A good statistics professor will tell you that a sample size of three does not establish a definitive pattern.  Current economic measures will also tell you that the U.S. economy is strong, unemployment is at historic lows, and GDP growth is still good.

 

Does this mean a recession is coming?

 

In a way, maybe.  Since the market cycle is either up or down (there is no sideways), if the current status of any given market cycle is up, then a down is somewhere in the future.  The reverse is also true.  Facts of life.  As we sit today, we have essentially been on an up for the past decade, so yes, a down is somewhere in our future.  But this yield curve inversion is neither necessarily the predictor nor the cause.

 

While a few of the U.S. treasury bond yields have inverted, other parts of the bond market are not signaling any kind of slowdown. This includes corporate bonds where high-yield and investment-grade indexes are both trading at tight spreads, but not inverting.  Other factors likewise seem to pour some cold water on the “recession is coming!” talk.

 

One of those factors is the reality of technology.  Today, technology has everyone, and everything, connected in a way that did not exist even five or ten years ago.  This means global markets, and especially their investors, can interact with each other much more quickly and easily than ever before.  One example involves European economies, which have been slowing.  This can, now more quickly than ever, drive European investors to other markets (read, U.S. markets).  More to the point, the German 10-year bond yield recently went negative and is still negative as of this writing.  So, everyone who was in the market for German 10-year bonds would likely look somewhere else for 10-year bonds (read, U.S. 10-year bonds).  That brings us back to supply and demand, and we could end up with decreasing 10-year yields, or even a yield curve inversion, that has absolutely nothing to do with the state of the U.S. economy.

 

As we touched on briefly above, the U.S. economy is still doing great.  Since it’s always nice to hear how great your own country’s economy is doing, let’s review just a couple more tidbits.  For such a long recovery (since the bottom of the 2007-08 recession), average monthly job creation is still higher than would ordinarily be expected this late into a market cycle.  Adding to the positivity, previously discouraged workers are coming back to the labor force.  Statistics show that the labor force participation rate has been increasing relatively steadily since it hit a low in September of 2015.  These two factors mean increased capacity for production in the economy as a whole, and increased income generation which leads to more consumer spending – both of which are good signs for any economy.

 

Finally, with the Fed’s strategy of quantitative easing and The Great Experiment of reversing that policy – again, never been tried before – we are looking at a completely new economic landscape that we’ve never seen before.  So, does that mean that previously tried and true indicators, such as a yield curve inversion predicting a recession, are no longer valid?  Unfortunately, we won’t know that answer until we can look back on it with 20-20 hindsight.

 

So, in the end, is a recession coming? Sure.  I can promise you that a recession or other downturn is somewhere in our future.  I can also promise you that a recovery and an upturn is in our future after that.  If all of this has got you thinking about your financial plan, then by all means let’s talk about it and consider your situation.  As opposed to having a real reason to be worried tomorrow, we would much rather our clients understand the potentials of the future and be comfortable with their plan today.

 

 

 

Sources and More Food for Thought

 

Bern, Mark; When a Yield Curve Inversion Means Recession; March 31, 2019; https://seekingalpha.com/article/4252015-yield-curve-inversion-means-recession?page=5

 

Bezek, Ian; The Yield Curve Inversion Won’t Cause A Bear Market; April 1, 2019; https://seekingalpha.com/article/4252073-yield-curve-inversion-cause-bear-market?page=5

 

Bureau of Labor Statistics; Civilian labor force participation rate; https://www.bls.gov/charts/employment-situation/civilian-labor-force-participation-rate.htm

 

El-Erian, Mohamed; There’s Danger in Misreading the Inverted Yield Curve – It doesn’t necessarily signal that a recession is on the way; March 24, 2019; https://www.bloomberg.com/opinion/articles/2019-03-24/inverted-yield-curve-doesn-t-necessarily-mean-recession-is-nigh

 

Federal Reserve Bank of Minneapolis; The Recession and Recovery in Perspective; https://www.minneapolisfed.org/publications/special-studies/recession-in-perspective

 

Hopper, Laura; How the Fed Is Reducing Its Balance Sheet – and Why; July 11, 2018; https://www.stlouisfed.org/open-vault/2018/july/how-fed-reducing-balance-sheet

 

LaBrecque, Leon; Recessions And Yield-Curve Inversion: What Does It Mean?; March 29, 2019; https://www.forbes.com/sites/leonlabrecque/2019/03/29/recessions-and-yield-curve-inversion-what-does-it-mean/#44a449c05890

 

Soni, Sankalp; How The Fed Could End Up Further Inverting The Yield Curve; Feb. 20, 2019; https://seekingalpha.com/article/4242455-fed-end-inverting-yield-curve?page=2

 

Srivastava, Spriha; The US bond yield curve has inverted.  Here’s what it means; March, 25, 2019; https://www.cnbc.com/2019/03/25/the-us-bond-yield-curve-has-inverted-heres-what-it-means.html

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