Who’s afraid of inverted yields?

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Once lionised as a key economic predictor, the inverted yield curve is less reliable than current headlines might suggest, says Shamik Dhar, chief economist, BNY Mellon Investment Management.

Much ink has been spilt in recent days about the yield curve and whether its inversion indicates a coming economic downturn. The curve, which delineates the difference in yield between long- and short-dated US government bonds, has variously been described as a barometer of global financial health, the ‘rock star’ of economic indicators, or even as a self-fulfilling prophecy and a catalyst for recession itself.

This is understandable. Every US recession since the Second World War has been preceded by an inverted yield curve (specifically by the yield on one-year Treasuries moving above that of 10-year Treasuries).¹

Today, the curve is teetering on the brink. On 14 August, the yield on 10-year US Treasury bonds briefly fell below two-year yields – the first time since 2007. Cue a stock market stumble as investors the world over sold out of equities on fears of a looming recession.²

But is this an overreaction? Very possibly, says Shamik Dhar, chief economist, BNY Mellon Investment Management.

For one thing, says Dhar, the inverted yield curve’s status as an economic predictor is overblown. “While its reputation for predicting the future was well deserved when monetary policy was ‘normal’ – when, generally speaking, recessions were generated by central banks – in the post-GFC world things are different.”

According to Dhar, in the 1970s, 1980s and 1990s, movement in the yield curve would work something like this: Central banks would note inflationary pressure which they’d look to squeeze out of the system by raising interest rates. This, in turn, would dis-incentivise spending and borrowing, thus creating conditions ripe for recession.

Bond markets cottoned onto this – and, so, as soon as inflation began to bite, would raise their expectations of short interest term rates while also reducing their expectations of long term rates. The result? An inverted yield curve ahead of any change in policy by central banks and before the dampening effects of higher interest rates could work their way through the real economy.

“But we haven’t had an inflation-led recession arguably since 1990,” says Dhar, “and even that one’s up for grabs. Recessions these days are more likely to be caused by financial variables going wrong and creating crashes. That’s true of the Asia crash in the late 1990s, it’s true of the dotcom recession, it was particularly true of the GFC and it was true of the eurozone crisis since then. The days of central banks engineering recessions through interest rate rises is gone – particularly in the current climate where, if anything, there’s a real fear of inflation undershooting and not reaching its target.”

And, if inflation has lost its central role as a catalyst for recession, then – unless the yield curve has become a good predictor of financial crashes – so too has the inverted yield curve as its precursor.

“This doesn’t mean the risk of recession isn’t rising,” concludes Dhar, “but it does suggest we should try to understand why the yield curve has inverted rather just blindly rely on it as a black-box indicator for the direction of future economic growth.”

¹Conversely, however, not every inverted yield curve in that period has resulted in a recession – evidence, says Dhar, of the need to distinguish between true negatives and false positives when discussing economic indicators.

²Source: Bloomberg: ‘The Market Finally Has Its Inversion. Now What?’, 15th August 2019

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