If you’re unaware of the implications of an inverted yield curve - In the last 50 years the US Treasury bond yield curve has inverted 9 times, 7 of which were followed by an economic recession. Earlier this year, the Treasury curve inverted for a 10th time since 1966, and in August, The UK’s Government bond yield curve inverted for the first time since the financial crisis of 2008.
WHAT IS A YIELD CURVE?
A yield curve fits the yields of equivalent credit quality bonds against varying term lengths. Longer term bonds typically have a greater yield, reflecting the greater risk investing at a fixed interest rate across a longer period of time. Therefore, a yield curve should typically slope upwards – however currently on both sides of the Atlantic, this is not the case.
If we can say that bond term demand reflects risk, then it follows that the shape of a yield curve reflects investor sentiment. If short term growth is uncertain and there is market volatility, investors may deem longer term bonds of lesser risk. An inverted yield curve therefore is a consequence of high demand for longer term bonds, driving their price up and their yield down. It is this consensus that predicts recession.
If we can say that the yield curve that predicts recession depends on investor consensus, is it fair to suggest that it may be a self-fulfilling prophecy?
The R word index implies as such. A study compiled by the Economist, it counted the number of mentions of the word “recession” in newspapers in the early 90’s and found that the rate closely mirrored economic growth. This process has been refined through the use of Google Trends, and the Washington Post reports that uses of the word have now reached 2008 levels.
Campbell Harvey, the Duke University Professor who discovered the link between the yield curve and economic recession, doesn’t think so however, and despite branding the situation “code red”, urges that the warning instead allows for risk management, claiming that “you cut back spending somewhat, but you avoid that very sharp hard landing”. He goes on to say that “the inversion is not a coincident indicator, but rather one that points to downturns six to 18 months or so in the future. So, businesses can react to it, for instance, by delaying spending plans until the storm passes.”
A recession is defined by a period of two successive quarters within which there occurs negative economic growth. The UK suffered growth of -0.2% in the first quarter of 2019, however a couple of months of positive growth means that it would take negative growth of an unlikely -1.5% during September in order for the entire second quarter to grow negatively. We therefore are most likely at least 6 months away from any potential recession.
Does the inverted yield curve suggest that we are guaranteed to fall into recession after that? Maybe. Maybe not. What is clear is that we should prepare for such at the very least.