Yield curve inversion is a recession warning
On Wednesday morning, the yield curve inverted, which, if you’re a halfway normal person, sounds extremely boring, but it sent the financial press into a tizzy.
It’s probably good for policymakers to be at least moderately alarmed by this, because worrying about possible recessions is part of how recessions get avoided.
This whole conversion is about fluctuations in the price of Treasury bonds, with “yield curve inversion” standing as a shorthand for the prices of different kinds of bonds arranging themselves in an unusual pattern.
Yields and their curve, explained
One way a government or company can borrow money is to sell a bond. A bond will have a face value (say, $100) and, like any loan, will pay an interest rate (say 3 percent). It will also have a maturity (say, five years). A $100 bond with a 3 percent interest rate and five-year maturity is like a $100 loan at 3 percent interest that needs to be paid back after five years. Another way of talking about it would be to say that this five-year bond yields 3 percent.
But bonds can also be bought and sold on secondary markets over time. So somebody might end up spending $110 to buy a bond with a face value of $100. The interest would still be calculated based on the original face value, so the yield is lower now that the bond is more expensive.
The US government sells lots of bonds with lots of different maturities, and people buy and sell them in secondary markets all the time. Consequently, on any given day you can chart a whole bunch of yields for Treasury bonds of different maturities. The Treasury Department even publishes this handy table:
You can draw a chart plotting the yields for the different maturities and you get a curve — the yield curve for that day.
Normally, the curve slopes upward somewhat steeply.
But recently it’s tended to be “inverted,” with the short-term bonds having higher yields than some of the longer-term runs. And then on the morning of August 14, the two-year bond’s yield ended up slightly higher than the 10-year bond. That’s a rare and potentially disturbing occurrence.
Who cares? This doesn’t sound important.
Okay, so here’s the deal. Normally, yield curves slope upward. All else being equal, people demand higher interest rates for longer-term loans because there are various kinds of risk involved in lending (in the case of Treasury bonds, that’s primarily inflation risk) and the risks get riskier over longer time horizons.
So for the curve to invert implies that investors are forecasting that something unusual will happen. Something that will push future interest rates down low enough to justify long-term yields being low despite the risks. Something like a future collapse in private sector investment demand that makes government borrowing cheap. Or something like a series of Federal Reserve moves to try to reduce interest rates and spur more economic activity.
In other words, a future recession.
And, indeed, if you look at the historical track record, every time the two-year/10-year inversion has happened, a recession has followed.
That’s what has people worried. The bond market appears to be forecasting a future recession.
Should I panic and sell everything?
No. Please do not do that.
If you get through to the end of this explainer, you will walk away with an understanding of what’s happening in financial markets that’s superior to that of the typical person. But I promise you that sophisticated money managers with access to large pools of cash and ultra-fast algorithms understand this better than either you or I do and have already assimilated this information and made trades based on sophisticated models. The prices of stocks and whatever else may or may not be in your 401(k) have already adjusted in response to those trades.
It is, of course, very possible that the smartest, richest people on Wall Street are nevertheless getting this wrong and prices will fall further in the future. But the odds are that you, reading Vox explainers on your phone, are not going to beat the professionals.
The only good way to plan for a recession on an individual level is to try to make prudent overall financial choices, exactly as you would even if you didn’t think a recession was likely in the near term.
But seriously, does this mean there’s a recession coming?
Look, it’s not a good sign.
But while the empirical link between past inversion events and recessions is real, it’s also clear if you look at the chart that there’s a time lag involved. That means there’s nothing automatic about this process. And while the theoretical link between recessions and inversions is real, there are also other sets of future financial situations — like a sudden spike in the value of the dollar — that could produce the same result.
Now, of course, a spike in the value of the dollar could cause a recession by killing export industries. Or it could be a sign of other problems (like a foreign banking panic) that themselves lead to a recession.
But — and this is the critical part — these are problems the Federal Reserve and other policymakers could respond to in ways that keep the American economy out of recession. Indeed, just as the fancy hedge fund managers and algorithmic traders are aware of the yield curve situation, so too is Federal Reserve Chair Jay Powell. He and the rest of the Fed board already started cutting interest rates because they’re worried about economic weakness, and they could try to take further steps to boost the economy. The past three times the yield curve inverted, policymakers failed to stop an oncoming recession, but that doesn’t mean they will fail again.
The other important thing to consider is that yield curves seem to have grown structurally flatter over time in developed countries due to a mix of stable low inflation and lower population growth rates. If curves are flatter in general, then inversion events may just start happening from time to time due to more or less random trading noise that doesn’t necessarily signal very much.
All that said, while you can spin out various reasons why last week’s inversion may not spell a looming recession, the fact is these inversion events have normally been followed by recessions. Under the circumstances, reassuring cautionary notes can only be so reassuring — it’s a distinct dark cloud in an economy that was mostly giving us good news all last year.