Quarterly Economic Outlook

Understanding yield curve inversions

Are yield curve inversions always followed by recessions?

Financial markets have learned the mantra that yield curve inversions are followed by recessions.

The result was a steep sell-off in equities and commodities in October and December, and a risk-off retreat into government bonds. Subsequently, and particularly after members of the Fed’s Federal Open Market Committee started to indicate a switch in interest rate and balance sheet strategy, the equity and commodity markets recovered strongly.

Is Wall Street’s mantra reliable? Do yield curve inversions invariably imply that a recession is imminent?

First, the shape of the yield curve depends on supply and demand in the bond and credit markets; it is not solely decided by policymakers at the central bank or at the national treasury.

Second, some yield curve inversions have been followed by recessions in the US (and elsewhere), but there have been numerous examples of recessions without yield curve inversions, as well as inversions of the yield curve without recessions. Numerous episodes from the past three decades of financial history in the US, Australia, Japan and Germany clearly demonstrate that the yield curve is not a reliable predictor of recession.

Third, when the Fed (or other central bank) deliberately tightens policy, slowing money and credit growth by raising shortterm rates, this typically inverts the yield curve and will typically be followed by a recession. However, it should be noted that it is the slowing of money and credit growth that causes the recession (because this restricts spending power), not the rising short rates alone. In other words, an inverted yield curve will normally be followed by a recession only when it is a symptom of tightening monetary policy. Currently the data show that the Fed is not trying to tighten monetary conditions - only to “normalise” monetary policy.

The growth of US broad money (M3, for example) and credit has not slowed since the start of 2018. Moreover, the Treasury yield curve has inverted mainly because of changed views about inflation and growth resulting from the fall in the oil price last autumn and the slowdown in consumer price inflation. Lower growth and inflation expectations have led investors to buy more long-dated Treasuries (pushing down their yield). In addition the US government has been issuing more short-term Treasuries to finance the increased federal deficit, pushing up their yield alongside Fed’s rate increases until December. The Treasury shifted its bond issuing strategy to increase short-dated issues in response to banks’ greater demand for safe assets under the new BIS (Bank for International Settlements) rule that banks must hold higher quality liquid asset ratios.

In summary, the recent yield curve inversion is more a symptom of shifts in supply and demand in the credit markets, not a result of Fed tightening. I therefore believe that it will not be followed by recession in the US any time soon.

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