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The inverted yield curve is an expression you probably have heard of due to its rubric as the best US recession indicator. However, there can be difficulty in assessing when to listen to this rhetoric given that yields are published in a number of durations. ABSI this week explains the yield curve and what information can be deduced from its mannerisms. 

A yield curve is a visual representation of what investors are willing to loan their money to borrowers over specific durations. In a perfect world, a yield curve is upward sloping from left-to-right, representing the logic that the longer duration the more inherent risk and therefore the higher return demanded by investors.

However, the world is far from perfect whereby the laws of supply and demand and the, somewhat erratic, nature of behavioural finance comes into play. Please note that yields can be in reference to almost any asset class, but moving forward I will be specifically referring to government yield curves. 

"Normal" Yield Curve

Source: Investopedia 

It is important to appreciate that a government yield curve is more capricious because the base rate, being the overnight “cash rate”, is set by the reserve bank and can be amended on a monthly basis. Gone are the days when people buy a 30-year bond and hold it till maturity, nowadays the bond market is dictated by professional traders and from this base overnight rate, the market extrapolates out yields for longer maturities based on “forecasts” on what the reserve bank will do next.

Source: World Government Bonds

An inverted yield curve occurs when longer-dated bond yields are lower than their short-dated counterparts. This phenomenon occurs due to the market preempting near-term actions by the federal reserve to cut rates. Remembering that the cash rate is a barometer of the economy, a cut in interest rates by the federal reserve indicates weakness in an economy and therefore a higher risk of recession. This doctrine is enshrined by the fact that for the past 50 years, every recession has been signalled by a sustained inversion 6-18 months prior.

Source: Financial Times

With so many different yield durations, it is important to note the spreads which carry the most weight. There isn’t a clear consensus on this but the most cited spread is between the 2y and the 10y which is currently inverted and has been for some time now. Continually, the 1y and 10y are also popular amongst economists and while this hasn’t inverted, it is currently flat, at 25 bps, and there are high expectations for inversion very soon. In contrast, a 2018 US Fed published paper found that the 18-month and 3-month spread had the best predictive powers, evidence that there isn’t a clear consensus. Looking at the table below, from World Government Bonds, the red shade indicates inversion and the yellow highlights the flat spreads.

Source: World Government Bonds

To finish, it is vital to put into context why federal reserves are raising interest rates. Extremely high and persistent inflation continues to burden global economies and, until it is brought under control, reserve bankers will have no choice but to continue to raise and hold high-interest rates. Therefore, it is my expectation that history will repeat, in a similar effect to the late 70s/80s, and the yield curve will remain inverted for some time yet. 

Read the Conversation:

Jack Colreavy: 

 ”One of the most reliable leading economic indicators of recession is what is termed the inverted yield curve. Now, a normal yield curve is upward sloping from left to right, however it can occasionally invert, which means the market is pricing in the Federal Reserve cutting short term rates, eventually in anticipation of economic weakness, ergo a recession. Now at the moment, interest rates have been set aggressively high in order to combat inflation, and given the persistence and the height of inflation, I don't believe that Federal Reserve banks will be able to reverse tack anytime soon. So we will see the yield curve inverted for some time yet. To learn more, please subscribe to, As Barclay Sees It, by clicking the link in the description.”

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