Is a US recession inevitable?

Many investors are fretting about the ‘inverted US yield curve’ and its use as an indicator of a future US recession.

Coupled with a run of soft economic data out of the US, Europe and other regions and angst is growing around global growth.

But I’m not sure the yield curve inversion is necessarily a portent of doom.

Yield curve basics

A yield curve is a line with the yields of bonds of lengthening maturity. It starts at the left with short-term bonds – such as the overnight central bank interest rate – then runs through bonds of one to ten years, and in some cases out to thirty years.

A measure of the yield curve is the gap between a short-term bond yield and a long-term bond yield. Normally, that gap is positive – the curve slopes upward from left to right – because investors demand an extra return to put their money away for a long period of time.

An inversion

But sometimes that gap goes negative, the yield curve ‘inverts’ and does the opposite of what it normally does – i.e. it begins to slope downward from left to right. That’s because short-term rates have become higher than long-term rates.

Why might a yield curve invert?

An investor would only rationally accept earning less from longer-term bonds if they believe that over time interest rates were going to fall. And the reason they expect rates to fall is because they are expecting some sort of economic downturn.

The thinking is that when the yield curve inverts, it’s a sign that the US economy is headed for a recession.

Cause for concern but also for caution

There is reason to be concerned about this because, historically, recessions in the US have been preceded by a negative yield curve.

But a bit of caution is also needed and there are three reasons that a yield curve inversion may not be cause for alarm.

1. The yield curve can give false signals (circled on the chart above). For example, it did in the mid-1980s and the mid-1990s. We got yield curve inversion and there was no recession in sight.
2. Sometimes the gap between the yield curve inversion and a recession can be quite long. The average length of time between inversion and recession is 15 months. So even if the yield curve inverts decisively today, a recession may not occur until mid-next year. The share market, however, historically looks forward three to six months, so it’s too early for the share market to start worrying about it. (After US yield curve inversions in 1989, 1998 and 2006 US shares first rallied more than 20 per cent.)
3. Finally, a whole bunch of other factors are pushing down long-term yields that may not be indicative of a looming US recession. The US Federal Reserve might cut interest rates – which is helping push down long-term bond yields – but that may actually support growth. We also have ongoing quantitative easing around the world, which is helping keep long-term bond yields down.

A positive picture

It is a concern for investors that the yield curve in the US has flattened, and in some cases, inverted. But it’s not necessarily a sign the US economy is about to go into recession.

Indeed, global stimulus tells me that, if anything, global growth will start to pick up as we go through this year rather than slide into recession. Europe is easing, China is stimulating, the US Federal Reserve is more dovish. We’re also seeing better confidence and a pick up in retail sales in the US and improved production data out of Europe. All that combined paints a positive picture.

So keep an eye on those yield curves but don’t obsess over them.