One of the most reliable recession indicators is the yield curve, which compares bonds’ short-term and long-term interest rates. Most of the time, long-term rates are higher than shorter-term rates. This rewards lenders for taking a bigger risk by loaning their money for a longer period of time. But yesterday, the yield curve inverted; long-term bonds' interest rates fell below short-term bonds' interest rates. Specifically, the 10-year Treasury yield fell below the 2-year yield.
What to Expect
This occurred before all nine U.S. recession since 1955, with only one false signal, according to the Federal Reserve Bank of San Francisco. Even then, the inversion predicted a significant slowdown. They found that on average, recessions occurred 6 - 24 months after inversions. Researchers Bernard and Gerlach (1996) found that the yield curve inversions also reliably predict recessions for countries around the world.
The inverted yield curve itself may negatively affect the economy. Banks usually borrow money in the short term to lend it out for the long term. But if the yield curve inverts, they would lose money from that kind of lending activity, so they reduce or stop it. This further reduces the availability and affordability of credit, which can hinder business growth and increase the odds of a recession.
Don’t bet against stocks rising just because the yield curve inverts. LPL Research found that since 1978, the S&P 500 rises an average 21% after the yield curve inverts before finally peaking. And Dow Jones Market Data shows that after the yield curve inverts, the S&P 500 often gains 13.5% after a year, 14.7% after two, and 16.4% after three.
The utilities and consumer staples sectors have had positive 6-month performance after all three yield curve inversions after 1980, according to CNBC. Utilities returned an average 8.59%, while consumer stables only returned an average 2.67%.
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What it Means
The yield curve inverts when long-term bond investors strongly expect a future economic slowdown that would lower inflation and interest rates. If bond investors’ fear of an economic slowdown is strong enough, investors’ increased demand for long-term bonds will push their prices high enough, and yields low enough, to invert the yield curve. This signals that the bond market strongly anticipates an economic slowdown. Also, tight monetary policy from the Federal Reserve can increase the chance of inversion, since the tight policy often involves raising short-term rates to make credit less affordable.
How do we know this? It’s all about how bonds trade and the risks that bond investors anticipate in their trading decisions.
When you buy a bond, you are buying a future stream of cash flow and a future payment. For instance, a bond might give you $100 per year for ten years and then $1000 at the end. If you buy this bond directly from the borrower when they first offer it, you will pay $1000 for it. But if you wait a bit until other traders already own those bonds, you have to buy from one of them.
Like stocks, these bonds trade like items at an auction, and if more investors want to buy them than sell them, investors will bid up their price to something higher, like $1050. Now, you are paying a higher price for the same future stream of cash flow and future payment. You’re paying $1050 to get $100 per year for ten years and $1000 at the end. When you pay $1050 for that bond instead of $1000, you get a worse return on your investment, or yield. This is why bonds’ yields go down when their prices go up, and vice-versa.
Two main risks affect a long-term bond’s value: inflation and interest rates. As we learned from the business cycle, inflation and interest rates will increase during economic expansions and decrease during economic slowdowns. Bond investors buy or sell in anticipation of these risks, so bond prices and yields tend to move before these risks actually occur.
Bond investors also face the risk that the borrower defaults (can’t pay back investors) or gets its credit rating downgraded, but this risk is low if they buy government bonds. Thus, inflation and interest rate risks are the main drivers of trading activity for long-term government bonds.
Why are inflation and interest rates so influential? Remember that bonds give you a future stream of cash flow and a future payment. If inflation rises in the future, all of those future payments have less purchasing power, so the bond market will think the bond is less valuable and bid down its price. Long-term bonds face the most inflation risk because they have the longest time to maturity, giving inflation the most time to do damage. Also, as we learned from the business cycle, rising inflation will raise the interest rates that other lenders must charge to make money. When other loans’ interest rates increase, bonds appear less attractive, making investors sell bonds and move their money into other lending opportunities.
So rising inflation and interest rates make long-term bonds less valuable, which causes bond investors to decrease the price they're willing to pay for them. Falling inflation and interest rates make long-term bonds more valuable, which causes bond investors to increase the price they're willing to pay for them. Logically, long-term bond investors buy when they expect inflation and interest rates to drop sometime in the future, and sell when they expect the opposite. This is why bond prices and yields tend to lead inflation and interest rates.
Long-term bond investors are more concerned about these factors since they’re exposed to them for a longer period of time. This is why long-term bond prices and yields fluctuate more widely than short-term bond prices and yields; investors’ expectations of long-term risks can vary significantly, so their desire to buy or sell long-term bonds will vary significantly. In contrast, investors expectations’ of short-term risks vary less significantly, so short-term bond prices (and thus yields) are pretty close to the Fed’s short term rates. This is why the 1-year Treasury yield so closely follows short-term rates set by the Fed.
Now you know the causes and significance of an inverted yield curve. If bond investors expect an economic slowdown that will decrease inflation and interest rates, they buy long-term bonds, which become more valuable as inflation and interest rates fall. This buying drives up long-term bond prices, which makes their yield fall. If bond investors’ fear of an economic slowdown is strong enough, investors’ increased buying of long-term bonds will push their prices high enough, and yields low enough, to invert the yield curve. This signals that the bond market strongly anticipates an economic slowdown.
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