The Yield Curve Has InvertedSubmitted by Headwater Investment Consulting on July 23rd, 2019
By Kevin Chambers
Campbell Harvey, an economist at Duke University, is most famous for his dissertation of doom. Well, that might be a little bit of an overstatement, but he was the first person to spell out the most consistent indicator of recessions ever found: the inverted yield curve. His research found that in 7 of the last eight recessions, including the 2008 crisis, when the yield curve inverted for an entire calendar quarter, a recession followed within a year. As of June 30th, the yield curve has inverted again (STAFF, 2019).
First, a little refresher on the yield curve. The yield curve refers to a plot of the different interest rates paid by US government bonds. Common sense would assume that a yield curve would gradually increase as the maturities of the bonds increase. For example, a 5-year bond will have a higher interest rate than a 3-month bond. This makes sense because, as an investor, you would expect higher compensation for locking up your money for an extended period. It’s the same as when you go to the bank and look at rates for CDs. The longer you tie up your money, the higher the interest rate.
But sometimes, this curve changes. Right now, short-term government bonds are paying higher interest rates than long-term government bonds. A 3-month bond is paying 2.14% whereas a 5-year bond is paying only 1.83%. This flip of rates is a signal that something is off. Harvey argues that because investors are so scared of the next few years, the demand for long term bonds is greater. Investors want to lock in a long-term guaranteed return. The higher demand pushes the price up, which forces the rates down. Nevertheless, investors are willing to take the lower interest rate because of their acute desire to lock in their rate now for several years.
However, even Harvey’s assessment should be considered with a grain of salt. Number one, we are working with extremely meager sample size; in only seven instances has this situation occurred. Secondly, using historical events to predict future ones accurately is unreliable. Furthermore, Federal Reserve actions in the last decade have been anything but typical. We have never seen low interest rates sustained this long. The Fed has also been engaging in massive amounts of US bond purchases in a process called quantitative easing, which the ramifications are still unknown. Third, the more globalized world has driven an increasing number of international investors to purchase US government bonds, still considered one of the safest investments globally.
Many factors surround the inverted yield curve and its effect on the economy. Is this time different? It’s hard to say. However, as Harvey says: “the alarm as gone off.” (Weissmann, 2019)
STAFF, D. T. (2019, July 1). IT'S OFFICIAL: THE YIELD CURVE IS TRIGGERED. DOES A RECESSION LOOM ON THE HORIZON? Duke Today, pp. https://today.duke.edu/2019/07/its-official-yield-curve-triggered-does-r....
Weissmann, J. (2019, July 3). The Single Most Reliable Recession Indicator of the Past 50 Years Has Officially Started Blaring. Slate, pp. https://slate.com/business/2019/07/yield-curve-bond-market-recession.html.