Has the Yield Curve Really Inverted?

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As most people know, an inversion in the yield curve is seen as highly predictive of a recession in the US. This makes the financial media eager to be the first to declare that an inversion has happened, and with major US stocks taking a dive in December – the worst performance since the Great Depression as it’s being reported – many analysts are pointing to the alleged curve inversion at the beginning of the month.

You’d think it’s pretty straight-forward to see if the curve has inverted or not, but there’s quite a bit of disagreement. Let’s go over this situation.

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How the curve works

The yield curve is the plot of bond yield rates (that is, the interest that is paid on US Treasuries). Short-term bills should have a lower interest rate than long-term bills, because the further out in time you are, the more uncertainty there is, so you want to be better compensated.

Also, the interest rates for different timed bonds is reflective of the real expectations that investors have about where interest rates will be in the future. This is not where they say the interest rate will be, but this is where they are putting money down that it will be.

If the Fed is expected to tighten rates over the next couple of years, then interest rates would be higher in two years time, so the two-year bond yield should be higher. Conversely, and this is the key part for the recession predictability, if the Fed is expected to lower rates in two years (because they are fighting an economic downturn) then the yield on two-year Treasuries will go down.

The inversion happens when short-term rates are higher than long-term rates, and that scenario has correctly predicted 9 of the last 9 recessions (10, if we count economic underperformance in the mid-’60s)

The reality on the ground.

So, have short-term rates gone higher than long-term rates? Well, this is what the yield curve looked like at the start of December 2018.

The breathless declarations of curve inversion were people pointing to the five-year rate being just below the two-year rate. Technically, that’s an inversion, and would understandably spook some investors.

However, this isn’t the most widely-used definition of a curve inversion, that is the difference between the ten-year note and the three-month bill. That difference is the one used by Arturo Estrella’s famous econometric analysis of the yield curve back in 1996.

For context, this is what the yield curve looked like on July 2nd, 2007, arguably the start of the sub-prime crisis and the subsequent recession (the first was Sunday).

While the curve has been getting flatter in the last couple of years, and even during December, it’s still not exactly flat in the context of a pre-recession plot. Here’s what the yield curve looked like just before the holidays.

The two-year and five-year are flat, and it’s instead the two-year and three-year that are inverted, and we have the three-month inverted. Not exactly a good sign, evidently, and probably doing the opposite of reassuring investors.

It’s not just the interest rate

Another factor to consider is that when the stock market goes down, that means investors are pulling their money out and it’s going into, usually, bonds. The thing is, though, US indices have been going down since October before any talk of inversion was mainstream.

A curiosity of the yield curve is that generally, it’s rather smooth. But there clearly is a “bump” covering the long end of bills to the short end of bonds. This happens to coincide with the largest share of Fed holdings (57% of the Fed’s treasury holdings mature between 90-days and five-years), which during the month let $54B in assets roll off their sheet. This month, that is slated to increase to over $60B.

The US Treasury has also stepped up its short-term issuance, and during all of 2018 did not issue any 20- or 30-year bonds.

What does this mean for currencies? Well, the flatter the curve, and the more talk of inversion, the more investors are going to want safe-havens. On the other hand, there are as many views on yield curves as there are economists, so maybe the more pertinent lesson here is to take media-driven proclamations with a grain of salt.

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