- Sovereign Debt
United States: Is the yield curve inversion signalling an economic recession?
On Friday March 22nd, the yield on a 3-month bill turned higher than the yield of a 10-year Treasury note for the first time since August 2007. This stylized fact is called a yield curve inversion and in the past 40 years, an inverted yield curve very often preceded recessions in the United States. Is this inversion an early warning signal of a recession? What are the mechanisms at work and when would the next recession begin? We believe these questions are of utmost importance for investors in the very coming months.
First of all, what does an inverted yield curve mean? A yield curve inversion happens when yields on short-term Treasury bills, notes, and/or bonds are higher than long-term yields. During healthy economic growth periods, the yield on a 30-year bond will be on average three percentage points higher than the yield on a 3-month bill. At this point, you will notice that this has not been the case for a long time in the United States. When investors believe they will face a tough economic period and that a recession is coming, they expect the value of the short-term bills to plummet soon. Indeed, given that recessions last about 18 months on average, if investors believe a recession is imminent, they willl want a safe investment for two years. They will avoid any Treasuries with maturities of less than two years. The supply and demand law then plays out at full speed and prices on short-term bills drop, i.e., yields on short-term maturities rise, and prices on long-term notes and bonds climb, i.e., yields on long-term maturities decrease. Gradually, the yield curve flattens to ultimately reverse when investors fear a recession.
The beginning of the previous yield curve inversion dates back to February 2006, when for five out of eight trading days the yield on a 3-month bill was higher than the yield of a 10-year Treasury note. It was not until July 2006 that the inversion resumed and intensified to last more than ten consecutive months. We know what happened then! A few months later, the United States was in recession, the strongest since the Great Depression in the 1930s. The current yield curve inversion the United States is experiencing does not seem very different from the previous ones. Indeed, the inversion started March 22nd lasted five consecutive trading days and ended on March 28th. But what can happen in the months to come?
Recessions have all been preceded by a yield curve inversion
What we already know is that a yield curve inversion preceded each of the last 11 recessions in the United States. It is therefore a very strong signal that this correlation highlights. Moreover, the average time between a yield curve inversion and the start of a recession is around 12 months. In addition, the role of monetary policy and therefore the role of the Federal Reserve (Fed) in the case of the United States was strongly criticized during the previous inversion of the yield curve. Indeed, the Fed had not hesitated to hike the fed funds four times afer the first yield curve inversion in February 2006, arguably precipitating the last recession. Currently, the Fed has already indicated that there will be no further rise in Fed funds this year, taking note of its past mistakes while trying to maintain momentum in its monetary policy.
Even if there are two conspicuous exceptions over the 13 last yield curve inversions, we think that given the gloomy economic context on the global scale, i.e., economic growth slowdown in China, trade war between the United States and China, increased probability of hard Brexit, a Europe in an economic soft patch, etc., the risk of recession is significant in the United States and could materialize between the second half of 2020 and the first half of 2021. This could have the effect of impacting the creditworthiness of the United States. However, the yield curve inversion should last in the coming months before drawing hasty conclusions.
To be continued…
Julien Moussavi, Head of Economic Research
Sources: Beyond Ratings, Datastream