The Atlanta Journal-Constitution
Will the 'powerful signal of recessions' come true?
You can try to play down a trade war with China. You can brush off the impact of rising oil prices on corporate earnings.
But if you’re in the business of making economic predictions, it has become very difficult to disregard an important signal from the bond market.
The so-called yield curve is perilously close to predicting a recession — something it has done before with surprising accuracy — and it’s become a big topic on Wall Street.
Terms like “yield curve” can be mind-numbing if you’re not a bond trader, but the mechanics, practical impact and psychology of it are fairly straightforward. Here’s what the fuss is all about.
First, the mechanics
The yield curve is basically the difference between interest rates on short-term U.S. government bonds, say, two-year Treasury notes, and long-term government bonds, like 10-year Trea-sury notes. Typically, when an econ-omy seems in good health, the rate on the longer-term bonds will be higher than short-term ones. The extra interest is to compensate, in
part, for the risk that strong economic growth could set off a broad rise in prices,
known as inflation. Lately, though, long-term bond yields have been stubbornly slow to rise — which suggests traders are concerned about long-term growth — even as the economy shows plenty of vitality.
At the same time, the Federal Reserve has been rais
ing short-term rates, so the yield curve has been “flattening.” In other words, the gap between short-term interest rates and long-term rates is shrinking.
On June 21, the gap between two-year and 10-year U.S. Treasury notes was roughly 0.34 percentage points. It was last at these levels in 2007 when the U.S.
economy was heading into what was arguably the worst recession in almost 80 years.
As scary as references to the financial crisis makes things sound, flattening alone does not mean that the United States is doomed to slip into another recession. But if it keeps moving in this direction, eventually long-term interest rates will fall below short-term rates.
When that happens, the yield curve has “inverted.” An inversion is seen as “a powerful signal of recessions,” as New York Fed Pres- ident John Williams said this year, and that’s what everyone is watching for. Every recession of the past 60 years has been preceded by an inverted yield curve, according to research from the San Francisco Fed. Curve inversions have “correctly signaled all nine recessions since 1955 and had only one false positive, in the mid1960s, when an inversion was followed by an eco- nomic slowdown but not an official recession,” the bank’s researchers wrote in March. Even if it hasn’t happened yet, the move in that direction has Wall Street’s attention. “For economists, of course it’s always been traditionally a very good signal of directionality of the economy,” said Sonja Gibbs, senior director of capital markets at the Institute of Interna- tional Finance. “That’s why everyone is bemoaning the flattening of the yield curve.”
Recession? Really?
Sure, it seems like a strange time to be worried about recession. Unemployment is at an 18-year low, corpo- rate investment is picking up steam and consumer spend
ing shows signs of rebounding.
Some economists on Wall Street think the economy could be growing at around a nearly 5 percent annual- ized clip this quarter. But if the current economic vigor is only reflecting a shortterm stimulus coming from the Trump administration’s tax cut, then some kind of slowdown is to be expected.
“It’s very hard to see what’s going to goose the economy further from these levels,” Gibbs said.
And the financial mar- kets can sometimes sniff out problems with the economy before they show up in the official economic snapshots published on gross domestic product and unemployment. Another notable yield curve inversion occurred in February 2000, just before the stock market’s dot-com bubble burst.
In that sense, the government bond market isn’t alone. Stocks have been in a sideways struggle since the S&P 500 last peaked Jan. 26. Returns on corporate bonds are negative, as are some key commodities tied to industrial activity.
An important caveat to the predictive power of the yield curve is that it can’t predict precisely when a recession will begin.
In the past, the recession has come in as little as six months, or as long as two years after the inversion, the San Francisco Fed’s researchers note.
In other words, there’s a reason to look at the yield curve skeptically, despite its prowess at predicting recessions.
The new fear gauge
As in all market moves,
perceptions of its significance mean the yield curve can sometimes become a feedback loop.
If enough investors begin to grow concerned about a recession, they will most likely put more and more money into the safety of long- term government bonds.
That buying binge would likely help flatten, or invert, the yield curve.
Then people will write articles about the curve’s sending a stronger signal on recession. And that could, in turn, drive even more peo- ple to buy into long-term bonds. Rinse. Repeat.
There’s also a practical impact.
But it’s not just psychol- ogy. The yield curve helps
determine some of the decisions that are the most crucial to the health of the U.S.
economy. Specifically, the flattening yield curve makes banking, which is basically the busi- ness of borrowing money at short-term rates and lend- ing it at long-term rates, less profitable. And if the yield curve inverts, it means lending money becomes a losing proposition.
Either way, the flow of lending is likely to be curtailed. And in the United States, where borrowed money is the lifeblood of economic activity, that can slam the brakes on economic growth.
The Fed’s hand
There is an argument to be made against reading too much into the yield curve's moves, and ithangson the idea that, rather than the free mar-ket, central banks have had a big influence on both long-term and short-term rates. After the last recession, central banks bought tril-lions of dollars of government bonds as they tried to push long-term interest rates lower to lend a help-ing hand to the economy. Even though they're reversing course now, cen-tral banks still own massive amounts of those bonds, and that may be keeping long-term interest rates lower than they would otherwise be. Also, the Federal Reserve has been raising short-term interest rates since Decem-ber2015 and has indicated it will keep doing so this year. So if long-term rates were pushed lower by central bank bond buying, and now short-term rates are beingpushed higher as the Fed tightens its monetary policy, the yield curve has nowhere to go but flatter. "In the current environ-ment, I think it's a less reli-able indicator than it has been in the past," said Mathew Luzzetti, a senior economist at Deutsche Bank.