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Yield Curve Inversion Does Not Mean Recession – Yet

Summary

Yield Curve has been flattening - fears of inverting.

Is this a sign of a recession?

Not really, just expectations of a rate cut.

Yield Curves reflect investor expectations about future developments in the bond markets and their perceptions of overall risk. Basically, the idea is that the longer the bond duration the higher the yield should be in order to cover the extra cost of keeping the bond for a long time; thus, longer duration bonds should have higher yields than short-term bonds.

Still, this is not always the case, and this is where expectations enter the equation: if bond market participants are expecting interest rates to decline in the future, they are more willing to secure their funds in the higher-yielding longer-duration bonds. Thus, as investors flock to longer duration bonds their prices increase and their yield declines, pushing it closer to short-term yields.

Another, and immensely more popular, justification for this reduction in bond yields is that investors fear that a recession is coming and they seek to secure their funds in the bond market. As the duration of the potential recession is unknown, they prefer to purchase long-term bonds, which offer both the benefit of safety and (usually) higher yields. The rationale remains the same: as investors move to longer-term bonds, their price increases and their yield decreases.

It is true that in most cases the two explanations coincide: when a recession is imminent, investors seek long-duration bonds both because they expect the economy to deteriorate as well as because they know that during recessions Central Banks lower policy rates.

The long and short bond rates have been converging for the past year, with the difference between the two fluctuating between 0.1 and 0.2 since January. While a slowdown in US economic growth has been confirmed, especially with the Q4 revision yesterday to 2.2%, the country’s performance still remains far from being recorded as a recession. Furthermore, Fed funds futures are pricing more than a 30 bps easing by the end of 2019, with the Reserve Bank of New Zealand being the first Central Bank to admit that the next rate move will likely be a cut.

The point to be made is straightforward: if growth persists above 2% in the first quarter of the year, the Fed will likely not move interest rates. In the opposite case, where growth declines below 2%, a more likely scenario given the effects from the US government shutdown in January, the Fed will likely proceed with some rate hikes, in order to boost domestic consumption.

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.