The Inverted Yield Curve: What it Means and Why it Leads to One Place - Recession

March 31, 2022


A key market gauge of the risk of future recessions flashed a warning signal on Thursday afternoon.

The yield on two-year Treasury bonds climbed above the yield on 10-year Treasury bonds, a phenomenon known as an inverted yield curve.

The yield curve is regarded as a reliable predictor of recessions, having inverted before each of the last eight recessions as measured by the National Bureau of Economic Research. The yield curve inverted in 2007, foreshadowing the recession of 2008-09; and, spookily, it inverted in 2019.


The yield on the 10-year Treasury fell to 2.331 percent on Thursday when the yield on the two-year Treasury was at 2.337 percent. After the brief inversion, the curve righted itself as the two-year fell to 2.335 percent while the 10-year rose to 2.345 percent.


With the curve that flat, however, another inversion is a real risk.


The difference between the yields on the two-year and the 10-year has been narrowing for weeks.


Other parts of the yield curve had already inverted, with the three-year Treasury bond yielding more than the five-year and the five-year more than the seven-year. Those yields, however, are not regarded as particularly reliable barometers.


Normally, longer maturity bonds have higher yields than shorter maturity bonds as investors demand a premium for locking up capital for longer. An inverted curve suggests that investors expect lower interest rates in the more distant future than they anticipate in the near future.


Typically, investors expect lower rates because they anticipate the Fed will have to lower its target to reverse or prevent an economic downturn.


In this case, it seems that the investors suspect that the Federal Reserve’s current path of tightening monetary policy—by raising its interest rate target, increasing the interest it pays on reserves, and allowing its huge stockpile of bonds to shrink as bonds mature—will have to be reversed in the future. It may indicate that investors think the Fed will overdo the tightening, pushing the economy into a recession.


Analysts dispute exactly why an inverted yield curve predicts recessions so reliably. Clearly, the 2019 inversion was not due to investors foreseeing the pandemic and lockdown that briefly threw the economy into a recession in 2020. Some analysts think an inversion can cause a recession mechanically, perhaps by reducing the willingness of banks to lend. Others say an inversion merely reflects murkier information that indicate a recession lies ahead.


When the yield curve inverted in 2019, there were many who claimed it was “different this time.”


That’s the case again. Some believe that the yield curve’s signal has been scrambled by the Fed’s expanded balance sheet and perhaps by the economic turbulence stirred up by the pandemic.


There’s also a question of whether the yield curve’s signal might be scrambled by the fact that Treasuries of all maturities now have negative yields, meaning they would lose money if inflation remains at the current level or even at lower levels expected for the next several years.


Some economists insist that it’s not the difference between 10-year and two-year yields that matters but the difference between the 10-year and three-month yields. With the three-month yield at 0.518, that part of the curve remains un-inverted.


There have been false alarm inversions in the past. The curve inverted in 1966 and briefly in 1998 without leading to a subsequent recession. Some would count the 2019 inversion as a false alarm also—although we cannot know whether we would have got a recession if not for the pandemic.


For now, there may be some comfort to be taken in the fact that the inversion was so brief that it had to be confirmed by CNBC looking at the digital ticker tape moment by moment. Many economists and analysts claim that only a lasting inversion is telling. But if the curve inverts again, which is all too possible given its flatness, that thread of hope will be cut.


There is a silver lining to inversions. Stocks tend to do quite well in the months following an inversion. Energy stocks, in particular, seem to do well in the aftermath of an inversion, according to research from Bank of America. At the conclusion of the roughest quarter for stocks in years, that’s sure to be a welcome reprieve.


SOURCE: Breitbart Business

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