George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario
Since the start of the year, investors around the world, economic pundits and commentators have been worrying about an impending inversion of the U.S. Treasury yield curve and what it means for the economy and stock market. Academics have measured the yield curve by the difference between the 10-year Treasury note and the three-month Treasury bill rate, while practitioners by the difference between the ten-year and the two-year yield. When the short rates exceed the long rate, the yield curve is said to be inverted.
Well, as of last Tuesday, they got what they were afraid of; part of yield curve inverted with the five-year note yield below the two-year.
Stock markets around the world tumbled. The Dow Jones and the S&P 500 declined by more than 3 per cent.
Why did the markets react so strongly? The fear of an inverted yield curve relates to historical evidence that shows that an inverted yield curve has predicted each recession since 1955. So are we in the threshold of an upcoming recession?
Here I need to backtrack and explain a few issues related to the drivers of interest rates and the drivers of the difference between the long yields and the short rates (i.e., the slope of the yield curve).
The general level of the nominal interest rate can be broken down into three components: 1) the real interest rate; 2) a premium for expected inflation; and 3) a risk premium. (I will ignore the risk premium related to a corporate security as I am referring only to government bonds. However, even government bonds are exposed to the risk of unexpected inflation and of economic activity.)
In the short run, the real interest rate is driven by the business cycle. When the economy expands, the real interest rate rises and when the economy contracts, the real interest rate falls. The long-term trend of the real interest rate is affected by factors that change only slowly, namely technology and demographics.
In the short run, inflation is driven by the heightened intensity of economic activity and the pressures it entails, among other things, on productive capacity and the labour and commodities markets. In the long run, it is taxes, economic efficiency and productivity that impact inflationary expectations.
Given the general level of interest rates, what makes the long-term yields exceed the short-term rates and vice versa? The slope of the yield curve is driven by the demand and supply of bonds at various maturities, but more importantly by expectations of future interest rates.
An inverted yield curve occurs when monetary authorities raise interest rates to cool down economic activity and expected inflation. Monetary authorities have a direct control on short-term interest rates, but little on long-term interest rates. But tightening of monetary policy increases short-term interest rates relative to future rates as market participants anticipate a slowdown or a downturn of economic activity in the future and lower inflation. The consequence of this is lower yields for long-term treasuries.
However, a recent paper by three Federal Reserve of Chicago economists titled “Why does the yield-curve slope predict recessions?” argues that monetary policy and resulting expectations about future interest rates may not be the only link between the yield curve and economic activity. Attitudes towards risk could be another driver of the slope of the yield curve. The authors decompose the yield curve into expectations and risk premium components. Expectations about future rates depends on market participants’ views about inflation and real interest rates in the future. The risk premium component reflects the uncertainty about (unexpected) future inflation and real interest rates.
They find that the tightening of monetary policy leads to an increase in the probability of a recession down the road. On the other hand, a decrease in risk premium is consistent with both a higher or lower probability of a recession, “depending on the source of the decline." They conclude by stating that “not all declines in the yield curve slope are bad news for the economy, and not all instances of steepening are good news either." With the trade wars and ballooning debt around the world overhanging financial markets, the likelihood of unexpected changes in inflation and economic growth has increased, and so it is possible that the risk premium on long-dated bonds may have declined making it unclear, according to the paper, whether the flattening of the yield curve is a harbinger of bad news.
There you have it. Not all flattening of yield curves (including negative sloping) are bad news for the economy, and not all steepening of the yield curves are good news for the economy, either. Back to square one: The currently observed flat or negatively sloped yield curve does not necessarily implies an upcoming economic slowdown or recession. There is still hope!