As the yield curve slips towards inversion, the recession warning light blinks red—again
2019 went down as the year of the yield curve inversion.
This classic sign of pending recession—when short-term government securities offer higher yields than longer-term ones—lingered for a “solid five months” from mid-May to October, according to Luke Tilley, chief economist of Wilmington Trust. It was the first time in years the yield curve had inverted.
The recession never came, of course—no small thanks to the Federal Reserve’s decision to return to more accommodative monetary policy, effectively cutting rates three times.
But now the warning signs are back. And it may be that other corrective actions by the Fed—pumping cash into the overnight lending market by buying short-term U.S. securities from banks—are effectively keeping the yield curve from going haywire once again.
Yielding to economic pressure
The Treasury sells securities of varying duration, whether measured in months or years. Under normal economic conditions, the shorter a bond’s term, the lower its yield (the interest rate it offers). The opposite is true for bonds that mature years out; investors expect a premium to have their money tied up for longer periods. After all, a lot more can go wrong over 10 years than it can over two.
An inversion then is a measure of upside-down markets logic. When demand is higher for short-term securities, the nominal rate it carries climbs. That makes sense. But when rates for short-term securities surpass those of longer-term ones, investors are telling the markets they have more confidence that things will work out better in the near-term—ergo, they expect future economic conditions to worsen.
If enough people and businesses feel that way, it might force them to curtail purchase, investment and hiring decisions, which in turn, can be enough to bring on a recession.
Because of the variety of bond durations on the market, there isn’t a single inversion scenario. Market watchers may focus on a pairing of say, a three-month bond verses a two-year bond, or the 10-year versus 30-year. The graph below shows the movement of yields for these treasuries from the beginning of 2018 to the most recent date in January.
From mid- to late-2019, some curves inverted. Most recently, the three-month and 10-year curves have come closer.
Investors differ in the comparisons they find significant. “We put more importance and value on the 10-year yield versus two-year yield,” Tilley said.
“We prefer to focus on 3M-30Y inversions because they have more consistently provided investors with a lead time of about 1.5 years to recession,” wrote Allen Sukholitsky, founder and chief macro strategist Xallarap Advisory, in a note to Fortune.
A full inversion of the three-month and 10-year aren’t necessarily the biggest worries for them. And even though the two curves did invert briefly on Tuesday, there is again some distance between the two now. However, there is the question of whether an inversion would be more pronounced without the Fed’s interventions.
The agency has been buying short-term Treasurys from banks since September. The Fed has looked to control spiking interest rates on overnight lending in the so-called repo market by injecting more cash into the system, increasing liquidity.
Although the Fed has insisted that the action is not quantitative easing (QE)—the massive purchases of long-term Treasurys it undertook as part of the reaction to the great financial collapse—financial professionals don’t see much difference. Many have come to call the current round “non-QE QE.”
In addition to controlling overnight lending, the current rounds helped depress yields on short-term Treasurys and ultimately closed the inversions gaps that emerged earlier in the year. As basic economics dictate, driving up demand for a bond increases its market price, which effectively reduces the yield. The Fed bought up about $400 billion the amount of Treasurys since last September—a big jump.
Not that the action is completely unusual. “This experience of them buying short-term securities is much more in line with what they did for decades in normal circumstances,” Tilley said. And it has kept short-term rates within the Fed’s target range. At the same time, “we believe it was part of their intention” to stop yield curve inversion, he theorized.
That may have implications for current conditions, as this next graph, focusing on the period from Dec. 2, 2019 through January 28, 2020, shows.
The graph shows that the three-month, ending with a 1.57% yield, was only a .08 percentage points from the 10-year on Jan. 28.
There are two trends evident here. One is that the three-month yield has stayed fairly flat, likely due in large part to the Fed’s intervention in the repo markets since last fall. Without that, the three-month might have been higher, accentuating any inversion.
The other trend is that inversion has come closer because yields on longer-range Treasurys have dropped.
“The behavior of the Treasury curve since September is a little bit disturbing in that we’ve had monetary stimulus come in,” said Ed Al-Hussainy, senior interest rate and currency analyst for Columbia Threadneedle Investments. “Despite all of this, 10-year yields basically never got above 2% since September. That to me signals monetary policy is still too tight.”
The drop in longer-rate yields suggests there has been increasing demand for the bonds. “A lot of people have thrown in the towel and said, ‘I don’t know, maybe interest rates are never going to rise that much, so maybe yields that looked disappointing maybe aren’t,” said Warren Pierson, managing director and deputy chief investment officer for Baird Advisors.
Now, the big question: Does the move towards inversion mean an increased chance of a recession? Most of the experts that spoke with Fortune didn’t think so.
“Our view is that this flight to quality [which means investment in longer-term U.S. government bonds] will be temporary, as long as we don’t see a further epidemic of what’s happening,” said Charlie Ripley, senior investment strategist for Allianz Investment Management. There is still steady growth, full employment, and plenty of consumers spending money, the last of which represents roughly 78% of GDP. “Until we see some deterioration in consumer behavior, the economy is going to chug along.”
But not everyone is so sure. “Consumer sentiment is terrific and the market is terrific, but all the surveys of CEOs say they expect a decline in the economy and I think, ‘Who’s got a better feel for that?'” said Peter Ricchiuti, a business professor at Tulane University who regularly speaks with small- to medium-cap company CEOs. “Everybody’s at least cautious. In the long run the strength of the economy is in the population of working age people.”
Birth rates are down in the U.S., as is immigration, both critical drivers of growth.
If 2019 was the “year of the inversion,” 2020 may turn out to be the year of “what does the inversion mean?”
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