Yield Curve Inversion: Markets Are Correct to Price In Higher Recession Risk
On 14 August, the yield spread between two-year and 10-year U.S. Treasury bonds moved below zero for the first time since February 2006. Though it has since widened back to positive territory, the move was significant because such “inversions” of the yield curve – in which short-maturity yields exceed those for longer-maturity bonds – have preceded nearly all recessions dating back to the 1950s. The move has also, understandably, made investors more wary of the economic outlook.
What’s behind the inversion – and are investors right to worry?
Researchers still struggle to understand why the yield curve historically is such a good predictor of recessions. Many hypothesize that when investors think a near-term economic downturn is becoming more likely, they prefer to hold longer-maturity bonds, causing the curve to invert. Others posit that a flat or inverted yield curve reduces the marginal profitability of new loans for bank and non-bank financial institutions (which tend to borrow short and lend long), thereby discouraging new credit creation and curbing economic activity.
Regardless of what underlies the relationship, we think markets are correct to price in a higher risk of recession. The U.S. has not been immune to the severe slowing in global industrial production and trade volumes. The U.S. manufacturing sector is already in a mini-recession (defined by two consecutive quarters of contraction), and weaknesses in sectors tied to the global economy (including manufacturing, exports, wholesale trade, and transport) have started to affect U.S. labor markets. In July, the six-month change in aggregate hours worked for production and non-supervisory workers contracted. And while indicators of real consumption growth have remained solid, the reduced hours paired with slower hiring should eventually hurt incomes and consumption.
Adding to these trends, tensions between the U.S. and China are heightening business uncertainties and disrupting global trade. Moreover, recent communications from some Federal Reserve officials have suggested that the Fed may be slower to react to a potential downturn, though various studies have shown that a “faster, sooner” central bank response could have economic benefits.