Risks of an Inverted Yield Curve: All about it!

“Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve. Furthermore, a negative term spread was always followed by an economic slowdown and, except for one time, by a recession,” Michael Bauer and Thomas Mertens, two Federal Reserve research advisors in San Francisco, wrote in a 2018 paper on the topic.

A keenly watched measure of the yield curve, term spreads, briefly inverted Friday March 22,2019— with the yield on the 10-year Treasury note falling below the yield on the 3-month T-bill — This had a major impact on the Dow Jones which fell more than 450 points at one stage, due to the potential predictability as an indicator of a potential recession.

When investors become nervous, they often abandon stocks and other risky assets and flock to Treasuries, which are among the world’s safest investments. This is what seems to be playing out over the past few days in  the US.

About Yield Curves

The yield curve is a simple curvy line that plots out bond yields across bond maturities (in terms of time). Typically, the curve slopes upward, with investors demanding higher yields to hold a longer term bond, given the risk of inflation,  liquidity and many other uncertainties.

An inverted yield curve is when the yields on bonds with shorter durations are higher than the yields on longer dated bonds. It’s an abnormal situation – and therefore assumes significance when it happens – and as per the San Francisco Fed researchers quoted earlier, often signals an impending recession. Inversions of that spread have preceded each of the past seven recessions, including the 2007-2009 contraction. Since recessions in the past have typically came around a year after an inversion occurred, the logical conclusion seems to be that a US recession will arrive by 2020.

Inversion and Recessions

According to past evidence, recessions last 18 months on average. If investors believe a recession is imminent, they’ll want a safe investment for two years. They’ll avoid any shorter dated bonds , typically below two years which will sends demand for bonds down, and sending their yields up, therefore “inverting” the curve.

During times of uncertainty, investors may also believe they will make more money by holding onto  longer-term bonds than a short-term one as the economy goes through near term turbulence. Therefore they express this preference via bond markets where they demand more yield for a short-term investment than for a long-term one.

Does it Always work?

Of course not as it is – at the end of the day – a variable that could have multiple causes though of course a sustained inverted has been predictive of many past recessions. The yield curve is only indicative of a recession and may neither definitive nor causal.

The New York Fed estimates that the probably of a recession in the next year based on the slope of the yield curve is only around 14 percent, compared to 40 percent right before the 2008 recession. And note that not every part of the yield curve is inverted- the difference between two-year and 10-year Treasurys is still 11 basis positive.

Many experts also opine that since so many Treasuries are now held by central banks, who have their own preoccupations and  issues to deal with, the yield curve may no longer be just US market-driven.

Some experts also argue that other recession indicators like unemployment rates are still not warning of any danger and therefore it may be premature to press the escape button.

Many analysts believe that the Fed may wish to avoid the inversion of the curve, and prompt it to move towards an easing mode in the near term.

However, past evidence outweighs any anecdotal evidence and if the inversion persists in the coming weeks, it could be a bad sign for stocks. Given that German long term bond yields have also become negative in the last one week, there is definitely heightened global risk.

So keep leverage light and sit tight and wait for opportunities as we believe overall the year should be good for emerging markets – remember the above also means the authorities may have to reduce short term rates and that crude prices may remain under pressure – and broad markets therefore should find support at regular times.

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