The yield curve finally inverts

Two-year Treasury yields minus ten-year Treasury yields chart

The moment investors have been fearing arrived this week. But what is a yield curve and why does it matter?

It’s finally happened. One of the more reliable recession indicators has signalled that a downturn is on its way. Earlier this week, after years of hovering threateningly on the threshold, the US yield curve finally inverted.

First, let’s explain what that actually means. A yield curve compares the yield on bonds (IOUs issued by governments or corporations) that have the same credit quality, but different maturities (the time remaining until the date that your capital is returned).

A healthy yield curve slopes up from left to right – in other words, bonds with longer maturities yield more than shorter-term ones. That makes sense – for most of us, most of the time, money today should be worth more than the same amount of money in a year’s time. So we expect to get paid for waiting.

As the yield curve “flattens” – that is to say, the gap between the yield on long-term debt and that on short-term gets smaller – it indicates that investors are more hesitant about future prospects. It suggests markets expect future rates to be little changed from current ones, which implies in turn that growth will be mediocre, and incapable of driving inflation and therefore interest rates higher.

Finally, when the curve inverts – namely, longer-term yields are below shorter-term ones – it implies that investors are very pessimistic. They are happy to lock in long-term yields today, because they expect them to be even lower in the future, which suggests they expect low inflation, or even deflation, which tends to go hand in hand with recessions.

In the US, the yield curve between the three-month and the ten-year US Treasury inverted some time ago. But the big news this week is that the curve between the two-year and the ten-year has also inverted. Why does that matter? Because the same thing has happened prior to every single one of the last seven US recessions, with recession following inversion within 24 months. There has only been one “false positive” in that time – the curve inverted in summer 1998. At that point, the Federal Reserve under Alan Greenspan undertook a series of cuts and a recession didn’t take place until March 2001. On this occasion, it may not be so easy.

The Fed cut rates last month, but the market deemed it insufficient. Unless we see more drastic action, it’s hard to see any reason to dismiss this signal. That said, note that stocks tend to continue to rise for some months after the curve initially inverts – Credit Suisse reckons that since 1978 US stocks have typically risen for an average of about 18 months after the initial inversion. But it’s another good reason to be wary of this overvalued market.