Why yield curve mat­ters

The Prince George Citizen - - Money -

For the first time since be­fore the Great Re­ces­sion, the yield curve on two- and 10-year U.S. govern­ment bonds has in­verted, a pos­si­ble warn­ing that an­other re­ces­sion is on the way.

On Wed­nes­day, the yield on the 10-year Trea­sury briefly fell be­low the two-year yield. By late af­ter­noon, the rate was 1.58 per cent 10-year yield and 1.56 per cent two-year yield. How­ever, the spread re­mains very nar­row, a rare oc­cur­rence as in­vestors usu­ally de­mand more in­ter­est for ty­ing up their money over a longer term.

This lat­est in­ver­sion is the re­sult of a steep slide in long-term yields as wor­ries mount that U.S. Pres­i­dent Don­ald Trump’s trade war may de­rail the economy. Broader mea­sures of the U.S. economy, mean­while, are not point­ing to an im­mi­nent down­turn. The job mar­ket, con­sumer spend­ing and con­sumer con­fi­dence all re­main solid to strong.

The Cana­dian Press asked Na­tional Bank of Canada Chief Econ­o­mist Ste­fane Mar­ion ques­tions about this phe­nom­e­non that prompted a sharp de­cline Wed­nes­day in North Amer­i­can stock mar­kets.

What is a yield curve in­ver­sion? It’s when the pay­out on a 10year trea­sury drops be­low a short­term bond, ei­ther a three-month or two-year rate. Long-term bonds typ­i­cally yield more than shorter ones to re­ward hold­ers for wait­ing longer to get paid, but an in­ver­sion re­verses that.

Why does it hap­pen?

Peo­ple are ex­pect­ing there’s go­ing to be slower growth ahead. His­tor­i­cally, it oc­curs when mar­kets be­lieve that mone­tary pol­icy has been tight­ened too much and that cen­tral banks will need to lower in­ter­est rates. What that means is the mar­kets be­lieve that we’re near the end of the eco­nomic cy­cle and there­fore ex­pec­ta­tions of rate cuts are be­ing built in the curve.

What does it sig­nal?

All re­ces­sions have been led by yield-curve in­ver­sions and since 1957, there have only been two false sig­nals when the yield curve in­verted but a re­ces­sion did not fol­low: 1966 and 1998. This is why the mar­kets fear the sig­nal of the yield curve be­cause it’s got a pretty good bat­ting av­er­age in terms of fore­cast­ing re­ces­sions. What’s unusual this time? Mone­tary pol­icy is not seen as be­ing re­stric­tive and cen­tral banks are ex­pected to lower in­ter­est rates even more. Re­ally, this trade war un­cer­tainty is start­ing to bite and the stress is not com­ing from the cen­tral banks so the in­ver­sion of the yield curve stems from tar­iff wars and un­cer­tainty.

Is this the first in­ver­sion in 2019? No. Three-month bonds in­verted with 10-year trea­suries in March. What’s unique is that the shorter-term bond in­verted be­fore the two-year bond. When the three-month bonds in­verted, some econ­o­mists warned that it may not be an ac­cu­rate fore­cast­ing tool.

Is the two-year bond in­ver­sion a bet­ter sig­nal?

Not nec­es­sar­ily. We’re not see­ing a col­lapse of con­sumer con­fi­dence or busi­ness con­fi­dence as we would nor­mally see dur­ing an in­ver­sion of the yield curve. This is the rea­son why I’m hop­ing that if the trade war does not es­ca­late we might be for­tu­nate that the cy­cle will be pro­longed and it will be the third false sig­nal af­ter 1966 and 1998.

How soon could a re­ces­sion be in the off­ing?

On av­er­age, a re­ces­sion hits within 10 months of a yield in­ver­sion.If you be­lieve this is a real sig­nal, well on av­er­age you have 10 months be­fore the next re­ces­sion, so since the in­ver­sion started last March, you could say that would mean a re­ces­sion early in 2020. Are Cana­dian bonds in­verted?

In fact, Cana­dian bonds in­verted be­fore U.S. bonds but aren’t seen as solid a sig­nal. Cana­dian 10-year bonds had a yield of 1.16 per cent, com­pared with 1.36 per cent for two-year bonds.


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