US Inverted Yield Curve: Part II - The Inversion and What It Means

Updated: Apr 4, 2019

by InvestCEE Staff, Chris Ball

Link here to Part I - Explaining the Yield Curve

Link here to Part III - Implications for CEE Economies

Photo by Chase Moyer at Unsplash

This article is part two of our series on the US Yield Curve's inversion and what it means. It builds on the previous article explaining the yield curve.

The yield curve looked normal one year ago. The data on yields in March 2018 showed a steadily higher yield for each US Treasury maturity date as seen in the graph below.

Source: FRED, Federal Reserve Bank of St. Louis and author's own calculation

The "Inversion" of the yield curve happened this year in the past weeks. Below is the data:

Source: FRED, Federal Reserve Bank of St. Louis and author's own calculation

First, notice that in 2018 the yields start at 1.71%, then 1.79%, then 2.06%, 2.33% and so on until 3.08% for a 30 year maturity. That is, they rise with each longer maturity. That's normal.

In 2019, however, the 1 month yield starts at 2.46%. This already reflects that interest rates are higher (recall that interest rates generally move together) since the US FED raised rates in 2018. But the inversion is that fact that the rates do not rise consistently. They start at 2.46% for a 1-month maturity and stay there for the 3 month and then already fall slightly to 2.44% for the 1 year maturity! That's not normal...that's the inversion!

I've highlighted when the inversion kicks in. Basically at the 1-year maturity. Often people compare the 3 month or 1 year maturity versus the 10 year maturity. This curve is inverted at all those points. Graphically it looks like this.

Source: FRED, Federal Reserve Bank of St. Louis and author's own calculation

Why would this happen?

First, the price of bonds and the yield on bonds are inversely related. And prices move with demand. So this could reflect a sudden increase in demand for bonds with longer maturities. That higher demand would drive up prices and down yields.

Demand could increase for a number of reasons. Two (opposite) reasons would be (1) that investors suddenly feel like things are going to get safer or more stable in the coming 2-5 years. If you feel political, you could claim, depending on your views, that "Trump will be out in 2 years" or that "Mueller cleared Trump and so he will get re-elected". But, in my humble opinion, politics aren't going to get any less messy over the coming 2-5 years and there isn't a big enough political change coming that would argue US Treasuries will suddenly get less risky. To believe that, you'd have to believe that the chance of US defaulting has suddenly changed and nothing happened to indicate that. So interpreting this as sudden "good news" seems wrong.

Second, recall (see US Inverted Yield Curve Part I) most interest rates move, they tend to move up and down with inflation generally (called "the Fisher Effect") and the US FED adjusts interest rates up to fight inflation and down to fight recessions. So, this would drive an inversion if everyone believed suddenly that the FED will lower interest rates in the coming 2-5 years for some reason, like fighting a recession.

This seems the most likely explanation. The last FED interest rate hike was in December. Many analysts feel that the FED raised too much and should not have raised interest rates in December. President Trump is blaming FED Chairman Powell for hurting US growth and this past week announced a new appointment, Stephen Moore, to the FED's Federal Reserve Board which helps determine interest rate policy. Moore is a known FED critic and, as a Trump appointee, certainly leans in Trumps "lower interest rate" direction.

At the same time, news continues to indicate that the global economy is slowing. The European Central Bank has announced lower interest rates to fight a European slowdown, China continues to slow and struggle with the US over trade, and the rest of the world economy seems to remain cool or to be cooling further.

All those reasons above indicate that US economic growth may very well slow and pull the US into a recession. That won't happen overnight, but the likelihood of it happening in the coming 2-5 years has been growing significantly.

Does a US Yield Curve Inversion Predict a Recession?

Not always, but seems likely to make such a prediction today. My answer is tied up with my explanation above. There is no reason that optimism and a suddenly improving debt-to-GDP situation or the expectation that the real economy would grow and inflation drop couldn't also drive a yield curve inversion. Both of those would be great things. So a yield curve inversion does not necessarily mean we'll have a recession. You have to take the bigger picture into consideration.

The bigger picture here suggests that the yield curve is inverting because market participants are themselves already predicting a recession and FED rate cut in the coming years. So in this case the inverted curve is indeed what we'd call a leading predictor of a recession.

Historically, the FED does use yield curve inversion as one of the indicators of a coming recession because the yield curve is like the bond market's way of communicating to the rest of the world. And the bond market is saying "we expect a recession".

A Final Word of Caution and Hope

All that being said, fundamentally, the yield curve is about yields, about interest rates. Technically, all we are arguing here is that the yield curve is telling us that market participants are likely expecting a FED rate cut in the coming 18 months or so. That would happen because of an economic slowdown (a recession).

There is absolutely nothing that says either (a) the world economy could recover (maybe the European rate cut stimulates the European economy, for example, or the US and China resolve their trade disputes) and the US would avoid a recession - it could even expand if exports grow - or (b) the market is right and the FED does cut rates in the coming 6-12 months which stimulates the US economy and we avoid a recession altogether. Both of those are likely scenarios, especially the US-China resolution and the possible FED rate cut helping the US economy. If either or both happen, the yield curve inversion would have predicted a rate cut but not a recession.

How will we know? We'll see how the world economy looks over the coming months and watch for coming rate decisions by the US FED. The FED probably won't act at their next meeting, but they should act by summer if the economy looks like it might slow further.

About the author

Chris Ball, PhD is the co-founder and advisor for InvestCEE. Chris serves as the Honorary Hungarian Consul for Connecticut, the executive director of the Central European Institute and the István Széchenyi Chair in International Economics at Quinnipiac University.