Inversion of the yield curve in the US; understand why investors care

Bond markets are giving a warning about the US economy’s growth prospects, just as central banks prepare to combat soaring inflation by raising interest rates.

The disparity between the short-term and long-term costs of government funding has narrowed dramatically in the large developed economies since the final quarter of last year. In the United States, a “yield curve inversion” took place last month for the first time since 2019 – an event that in the past has served as a harbinger of economic downturns.

“Historically, a recession tends to happen in the United States a year after the curve reverses, even though the variation is large and there are occasionally false indicators,” said Priya Misra, who heads global interest rate strategy at brokerage TD Securities.

What is a yield curve?

Investors don’t have a crystal ball, but the yield curve is a good substitute.

The yield curve shows the rates that buyers of government bonds demand before lending their money for varying periods of time — whether overnight, a month, ten years or even a hundred years.

Because lending money to the governments of large, developed economies such as the US, Germany, Japan and the UK is considered a safe bet, these borrowing rates are primarily influenced by investors’ assessments of the prospects for economic growth and inflation, and for the effect this will have on central bank interest rates.

The US interest rate curve, especially –thanks to the dollar’s ​​central position in the world financial system–, works as a kind of barometer of the collective wisdom of investors about the future course of the largest economy on the planet, and its track record in terms of signaling downturns before they occur is strong.

“People get excited about the yield curve because, historically, it has always been a good predictor of recessions,” said Richard McGuire, fixed income strategist at Rabobank.

The yield curve is generally upward, meaning that lending money for longer periods provides a higher fixed rate of return. The yield on shorter-term loans tends to represent what investors believe will happen to central bank policies in the near future. Longer maturities represent investors’ best guess about the direction inflation, growth and interest rates will take over the medium to long term.

However, when an economy is slowing and inflation expectations fall, yields on 10-year and 30-year bonds typically fall toward those offered on shorter-maturity securities, such as three-month and two-year notes, since that investors are betting that there will be less need for central banks to raise funding costs in the future; instead, they may have to encourage spending.

This flattening of the yield curve may at some point become a recessive signal, especially if the curve reverses and becomes downward, as happened last week. An “inversion” of the yield curve preceded each of the recessions that occurred in the United States in the last five decades.

There are two possible explanations for this predictive power, explains McGuire. One is that operations in the US$23 trillion US Treasury bond market serve as a kind of early warning system, identifying approaching dangers that individual analyzes may struggle to detect. The other is that changes in the shape of the curve play an active role in triggering downturns because they undermine confidence in the economy.

During periods of economic expansion and very accommodative monetary policy, in which governments resort to low interest rates to encourage spending and stimulate economic activity, the yield curve becomes steeper. This happened during the 2008-2009 financial crisis and early last year, after the recession caused by the pandemic.

The reason for this turnaround is that bond investors anticipate higher yields in the future, because a stronger economy can generate a faster pace of inflation if demand in the economy begins to outstrip the supply of goods and labor. In this scenario, the central bank will at some point need to adopt higher overnight rates in order to encourage people to save more rather than spend.