Yield Curve Inversion (and Recession) on The Horizon?

April 18, 2018
Author: Jordan Fuentes, MBA

Yield curve inversion, in its simplest form, occurs when long-term interest rates are lower than that of short-term interest rates. Throughout this article, any references to interest rates are considering the United States Treasury issued debt instruments. U.S. Treasury issued debt has higher liquidity, is considered risk-free, and supplies the most up-to-date yield information. When the yield curve inverts, a recessionary period tends to follow shortly thereafter (discussed further in this article). A recession is defined as a period of temporary economic decline during which trade and industrial activity are reduced, which is generally identified by two consecutive quarters of negative economic growth, as measured by a country’s gross domestic product (“GDP”). Since 1976, the United States has experienced four major recessions, with the most recent ending in June of 2009. The remaining three recessions took place in 1981, 1991, and 2000. An analysis of the prior four recessions indicates an average duration of 2.87 years, with an average period since prior recession of 6.19 years. On average, GDP has declined 2.38 percent from peak to trough during the four recessions. Although there is no definitive way to predict a recession, an analysis of interest rate spreads can be helpful to project a yield curve inversion in addition to other qualitative factors.

The Cause of Yield Curve Inversion
Yield curve inversion is driven by investors deploying capital to long-term bonds in favor of short-term bonds. As a result, the influx of capital drives the interest rate of the long-term bond lower and the short-term bond higher. In addition to the lack of inflow driving short-term interest rates higher, the Federal Reserve may determine to increase the Fed Funds rate to make the short-term instruments more attractive. The flow of capital to long-term bonds tends to break logic as any rational investor would prefer to earn a larger return in a short-term period; however, the increase in short-term interest rates is indicative of a lack of demand for the short-term bond. The lack of inflow to short-term bonds can be indicative that investors are uncertain in the economy and would prefer to invest in a long-term instrument which is not subject to short-term economic or re-investment risk. To caveat that theory, long-term bond demand is reduced when uncertainty increases and, while re-investment risk is minimized, there is uncertainty around inflation which may add additional risk to return expectations. In addition, long-term bonds have a greater duration, and some investors may invest in shorter-term bonds to manage duration risk with a barbell strategy. In the end, the causes of yield curve inversion can be numerous, are consistently debated, and subject to scrutiny.

Interest Rate Spreads
Similar to yield curve inversion theory, an analysis of interest rate spreads can be useful in determining probability of a recession occurring. An interest rate spread is the difference between the interest rates of a longer maturity bond and a shorter maturity bond and is quoted in “basis points” (basis points are one one-hundredth of a percent, where 50 basis points is 0.50 percent). Some of the popular interest rate spreads to analyze include the 10-year treasury bond and 3-month T-bill, 10-year treasury bond and 2-year T-bill, and the 30-Year treasury bond and 2-year T-bill. The most heavily analyzed is the 10-year treasury bond and 2-year T-bill (“10-2 spread”). Analysts look at the 10-2 spread due to the 10-year bond being indicative of the expectation of being compensated for increased risk associated with future economic growth and inflation expectations, and longer duration. The 10-2 spread has ranged between 0 and 250 basis points 80.7 percent of the time since 1976. When the 10-2 spread narrows or turns negative, this can be indicative of the preference to invest in longer-term instruments than short-term instruments due to the facts mentioned in prior sections. Exhibit A shows the relationship amongst the 10-2 spread and recessions occurring shortly after the spread is negative.

 

 

Recessionary periods are indicated by grey boxes. Although some time may pass before the recession occurs, the negative 10-2 spread occurred before the recessions of 1981, 1991, 2000, and 2008.
In addition to the 10-2 spread, an analysis of the 10-year treasury bond and 3-month T-bill (“10-3 spread”) has shown a correlation amongst spread values and the probability of a recession. Exhibit B shows that when the 10-3 spread contracts (and goes negative) there is an increasing probability of a recession occurring within one year.

Exhibit B: Recessionary Probabilities

Source: Federal Reserve

 

Indications of a Recession on the Horizon
The most recent recession in the United States took place in 2008 and lasted approximately two and a half years. With a recession happening once a decade since 1976, and most recent recession ending in 2009, there is reason to begin analyzing the current yield curve and interest rate spreads to determine if there is a possibility of stagnant or negative economic growth in the near future. Exhibit C shows the yield curve over a range of dates beginning January 4, 2016 and ending March 29, 2018.

Exhibit C: U.S. Treasury Yield Curve

 

The yield curve has continued to show a flattening effect, with the short-term interest rate rising at a greater pace than the long-term interest rate. Although short-term interest rates have recently increased, there was an increase in the yield spread (as shown in Exhibit D), which has been largely driven by the recent tax reform, which took effect in fiscal year 2018.

Exhibit D: 10-2 Spread, Shorter Horizon

 

In addition, Exhibit D shows the 10-2 spread beginning in January 4, 2016 and ending March 29, 2018. The 10-2 spread is now below 50 basis points, which has not occurred since August 15, 2017. The recent increase in the short-term interest rates has been driven by the Federal Reserve raising the Fed Funds rate once in 2016, three times in 2017, once in 2018, and two additional proposed increases in 2018 as of March 29, 2018. Analysis of yield curve inversions and recessionary periods occurring since 1976 indicates that on average a recession takes place approximately two years after the yield curve inverts. In conclusion, the flattening of the yield curve and narrowing 10-2 spread is beginning to signal signs of a possible economic slowdown and recession in the near future.

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