The financial world has been atwitter about the inversion of the yield curve. It is a phenomenon in the bond market in which longer-term interest rates fall below shorter-term interest rates, and has historically been a warning sign that a recession could be on the way.
This all seems obvious to people who are steeped in bond-market math and the workings of fixed-income markets, and can be completely perplexing to those who are not.
Maybe a sports gambling analogy will make the intuition clearer.
Any adult can walk into a casino and bet on how an NFL team will do this year. For example, bettors once again expect the New England Patriots to be an excellent team – that they are likely to win 11 or 12 out of their 16 games. Casinos will let you wager on how many games they will win this season.
But what if casinos not only would let you bet on how a team will do this year, but how they will perform over the next, 2, 5, 10 or even 30 years? What would you pay for a betting slip that promises, say, a $10 payout for every Patriots regular season win in the next decade?
And what if you could then sell that slip to other gamblers, with its price rising and falling as bettors’ views on the outlook for the Patriots changes? Essentially, you could take the price that people are paying for those slips with different durations, and, with some simple math, figure out how many games bettors expect the team to win each year in the future.
That’s kind of what the bond market does with interest rates. Bonds that mature at different times are always trading on global markets, and with some fairly simple math you can figure out what the price of different bonds implies about how interest rates are expected to change over the coming years.
Interest rates are closely connected to the rate of economic growth and inflation. In boom times, lots of people want to borrow money, to expand their businesses, say, or buy houses. And the U.S. Federal Reserve will raise the interest rate that it controls in order to prevent the economy from overheating, resulting in inflation. When a slowdown comes, the process works in reverse.
If you buy, say, a 90-day Treasury bill, you are likely to receive an interest rate that is closely tied to whatever the Fed has currently set as its main target for interest rates in the banking system and any changes the central bank may make in the near future.
It’s like betting on next week’s game: We know a lot about what opponent your team is facing, how well they’ve been playing, whether there are injuries that are likely to affect the outcome.
But if you buy a 10-year Treasury note, you’re making a bet on the more distant future. The economy will probably change a lot over the next decade. You can’t predict exactly what will happen, but you are betting on the general direction of things: Do you expect the economy to heat up, creating inflation pressures and causing the Fed to raise rates? Or do you expect it cool down?
So purchase of a longer-term Treasury bond is like making one of those long-term bets with a casino on how a team will perform for many years to come. You have no idea what the details are of which players they will sign or who will be coaching the team. You are betting on the general direction.
How might that bet might look with two different teams?
The Arizona Cardinals were terrible last year, and most bettors expect them to be pretty bad this year as well: Vegas odds suggest they will only win five or six games. But they have drafted an exciting young quarterback (Kyler Murray) and hired a new coach.
Even if you’re not a believer in the Cardinals for this season, you could reasonably expect that they will get better in the coming years – that their future is better than their present. If most bettors believed that, you could tell that from the difference between the price of a 10-year Cardinals betting contract and a one-year Cardinals betting contract – it may reveal, for example, that the team is expected to go from winning five games this year to nine games two or three years from now.
Or consider the Patriots. They have been the best team in the game for the past two decades, but their quarterback, Tom Brady, is 42 years old, and their coach, Bill Belichick, is 67. It would be reasonable to expect the team to decline over the next decade after these stars retire.
The prices of the Patriots one-year contract, in other words, would probably reflect greater optimism than their 10-year contract.
Essentially, the relative prices of those short-term versus long-term betting contracts would tell you whether a team is viewed as likely to be on the upswing or the downswing – not necessarily today, but at some point in the next few years.
That’s exactly what the yield curve is doing: It is telling us the difference between shorter-term and longer-term interest rates, and hence whether investors expect the economy to get better or worse in the years ahead. Our fictional Patriots yield curve is inverted, and so is the actual U.S. Treasury bond yield curve.
The moves in the bond market over the past nine months and especially the past couple of weeks are the equivalent of what would happen if Mr. Brady and Mr. Belichick both announced that this would be their last season before retiring. The current outlook remains stable, but the outlook for the coming decade has gotten worse.
Longer-term rates below shorter term rates are a clear signal from bond investors that they think the U.S. economy is on the downswing – that its future looks worse than its present.
It’s the opposite of times like 2009, when the economy was in recession and the yield curve pointed to future improvement. At those moments, the United States more resembled the Cardinals, a bad team but with room to improve in the coming years and (potentially) the tools to do it.
The good news is that this is merely the best guess of investors with trillions of dollars on the line. It could be wrong. Maybe the Patriots will pluck another Brady-esque quarterback in the draft, Mr. Belichick will coach until he is 80 and the team will remain a perennial Super Bowl contender. Market prices can be wrong!
And similarly, maybe the negative signals about the global economy will turn out to be overdone, and the U.S. economy will continue improving despite what the yield curve is suggesting now.
A lot of surprising things can happen in one NFL season, let alone across years of them. That’s even more true for the global economy.