Have Inverted Yield Curves Become the Norm?

by: Prakash Kolli

I was looking at the economic and financial indicators pages of the latest issue of The Economist yesterday and was surprised to see the large number of countries with inverted yield curves (comparing 3-month bills and 10-year government bonds).

The magazine lists the interest rates of 42 countries and the Euro area, which has a common short-term rate of approximately 3.84%. Two countries, Argentina and Saudi Arabia, do not have listed rates for 10-year bonds; presumably they do not issue them.

Of the remaining 40 countries, 19 have inverted interest rates, meaning almost 50%. The list includes the United States, China, Britain, Canada, Hungary, Russia, Australia, Hong Kong, Indonesia, Pakistan, Singapore, South Korea, Taiwan, Thailand, Brazil, Colombia, Venezuela, Egypt, and South Africa.

Of interest is Brazil, which has the most inverted rate of all countries listed with a 3-month rate of 12.94% and a 10-year rate of 6.16%. Russia, Pakistan, and Venezuela also sport double digit 3-month rates of 10 – 10.5% and single digit 10-year rates of 6.23 – 6.7%.

The basic reason for inverted yield curves is that investors are willing to buy longer-term bonds with lower yields, since they feel short-term rates will drop soon in response to future weakening economic conditions. This reasoning would imply that most of the World’s economy would be undergoing a slow down or a recession sometime in the near future.

There are, however, other reasons for the observed inversions, such as the build up of foreign reserves by Asian and oil-producing countries. Additionally, the yen-carry trade has contributed significantly to the inversion. Since the 3-month (0.45%) and 10-year (1.69%) rates within Japan are so low, investors can borrow in yen cheaply and invest in relatively safe U.S., Australian, or U.K. bonds or even higher yielding emerging market bonds.

Inverted yield curves have been relatively reliable predictors in the past of recessions and/or economic slow-downs. I am not sure, however, that the current inversions are signaling a recession for this many countries. Clearly if the yen carry trade is reduced, then long-term yields for many countries would increase. The continued unwinding of the yen carry trade this past week shows the results of such actions. The U.S treasuries gained while those of emerging markets lost and equity markets around the world dropped significantly. Fundamentally, however, the conditions for prolonging the yen carry trade still exist, and interest rates in Japan are still low when compared to the rest of the World.