What is the Yield Curve and Does it Really Signal a Recession?

Context for an important measurement of bond investor sentiment.

By Scott McIntyre, CFA
Senior Portfolio Manager
Managing Director
HilltopSecurities Asset Management

 

After the inversion of the yield curve last month, market analysts and policymakers engaged in a wildfire of discussion, speculation, and debate surrounding the slowing of the U.S. economy, the plunge in stock market prices, and the possibility of an upcoming recession.

But what exactly is the yield curve, and why should we keep an eye on it? Moreover, is it truly a proven indicator of an oncoming recession? This blog seeks to provide context for the recent chatter surrounding this very important measurement of bond investor sentiment.

What happened in August?
In a nutshell, U.S. stocks plunged on August 14 and the Dow booked its worst single day of trading in 2019. The reason? You guessed it. For the first time since 2007, the yield curve inverted when the 10-year treasury fell below the two-year treasury, yielding 1.6 percent versus 1.603 percent respectively.

The yield curve has since inverted several times. On August 23, the spread between the 10- and two-year yields inverted following President Trump’s order to look for alternative trading partners outside of China, which only marred investor sentiment. Then, on August 27, we saw the yield-curve inversion deepen further. Spurred by continuing trade tensions, a global bond rally caused the 10-year yield to fall and trade approximately four basis points below the two-year yield.

What is the yield curve and what is an inversion of it?
The yield curve is essentially the difference between long- and short-term interest rates on U.S. government bonds. Historically, an inverted yield curve (when the short-term yields move higher than the long-term yields) has been a very reliable predictor of economic recessions and is closely monitored by policymakers.

The yield curve is a leading indicator of the business cycle, and the delay between an inversion of the curve and the beginning of a recession has ranged from six to 24 months. The inversion of the yield curve has correctly signaled all nine recessions since 1955 with the exception of only one “false positive,” which occurred in the mid-1960s, when an inversion of the curve preceded an economic slowdown but not an official recession.

Is a recession nearing?
A recession isn’t certain and there are reasons to be confident in the U.S. economy. The unemployment rate is low—holding steady at 3.7 percent in July—and inflation remains in check at 1.8 percent for the 12 months ended July 2019 compared to 1.6 percent previously, according to the U.S. Labor Department’s August 13 report.

However, many key indicators suggest we may be nearing an end-of-cycle environment. Along with yield curve flattening and inversions, higher borrowing costs, the projected 2020 end to the fiscal stimulus caused by tax cuts, and the tariff war with China slowed U.S. economic growth in the second quarter.

Whether or not the yield curve can predict a recession with any certainty is up for debate. Many Fed policy makers, like New York Fed President John Williams, contend that the yield curve is only one consideration when talking about the future of the economy.


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