The yield curve is a picture of interest rate yields of debt with different maturities. Typically, one expects the longer the maturity, the higher the interest rate an investor would require since there is more uncertainty as time goes on.
There are times when the yield curve will invert. That means that shorter term rates will be higher than longer term ones. We see this happening in the U.S. government debt market now. I pulled the October 10 close of the U.S. Treasury constant maturity market. A one-month T-Bill was yielding 1.74%. All maturities from the three-month to the 10-year debt were at lower rates than the one-month, with the 5-year at the lowest rate of all maturities at 1.48%.The 20 year and 30-year bonds were higher, with rates of 1.96% and 2.16%, respectively. Overall, this gives more of a bowl-like shape to the yield curve.
The Federal Reserve Bank of St. Louis has tracked yield curve inversions with the difference between the 10-year Treasury less the 2-year Treasury. When the difference is negative, they count this as a yield inversion. At the time I write this, the difference between the two rates is a positive 14 basis points. Pretty small indeed!
Since 1978, there have been five different recessions, that is two consecutive quarters of negative GDP growth. All five of these have been predicted by an inverted yield curve which gave a warning light from 10 to 22 months prior to the recession. As I look at these different inversions, my first question is why did the curve invert?
The first one comes in the fall of 1978. The Federal Reserve manages the Fed Funds Rate, or the rate for overnight lending to banks. In summer of this year, this rate stood around 8%. By the end of the year, the rate had spiked to nearly 14% with some Fed tightening. Recession started in January of 1980. Later in 1980, the Fed eased a bit and Fed Funds dropped to 9.5%. Then in the fall again, Fed Chair Volker determined to eliminate excess inflation from the economy, and we watched rates jump to over 20%. It did help wring out inflation but threw the economy into a recession in mid-1981.
Both these are times when the Fed increased rates which caused the inversion as short-term rates shot above longer-term ones. The next inversion, in fall of 1989, came as the Fed was easing rates. Fed Funds had bottomed out in the fall of 1986 at 5.75% to a peak around 10% in the spring of 1989. Then the rates began to ease by a point before the curve inverted in August 1989. Recession followed in summer of 1990.
We enjoyed a decade of growth in the 1990s. Rates fell to around 3% in 1993 and rose to 6% in 1995. Fed Funds rates stayed around the 5-6% range until rising to 6.5% in summer of 2000, giving us our 4th yield curve inversion. Recession began in March 2001 with the dot com tech bust.
Our final inverted curve hit in February 2006. Fed Funds had sharply dropped after the 2001 recession and bottomed at 1% for most of 2003 to mid-2004. The Fed began tightening in the summer of 2004 with a steady march up to 5.25% in July 2006. The curve inverted in February 2006 and recession, now referred to as the “Great Recession” began in December 2007 after the crash of the financial markets in the fall.
The Fed reacted quickly during the crash and we saw the Fed Funds rate drop their target rate to 0.25%. This rate stayed pretty much the same for over six years, until the Fed began to methodically raise rates in quarter point intervals until a peak around 2.25% in early 2019. We have seen a few reductions in the rate to the current target rate of 1.75 to 2%.
Back to the original issue, why is the yield curve inverting and does this mean a recession is on the horizon? For that, I have a few take-a-ways.
All interest rates have a base in a normal positive yield curve on the Federal Reserve’s Fed Funds Rate. It seems like most of the inversions happened during periods of Fed raising rates to slow down the economy. A couple of inversions seemed to come as the Fed was attempting to reverse course after rate increases.
The magnitude of the rate swings was also much greater. The gaps ranged from an interest rate trough to peak from a minimum of 3.5% to over 10.5% before the recessions. Our current interest trough to peak of Fed Funds was only about 2.5%. It was not uncommon in the past to see 1% rate increases at Federal Reserve Open Market Committee meetings. Now we only tend to se 0.25% changes. The Fed has been more accommodating lately and it is hard to argue that as small of the magnitude of the rate increases, we have seen from 2016 to 2019 would trigger a recession, based on some of the past data.
One reason to consider the current flattening of the yield curve may be the strength of our economy and the yield on our government bonds, which is low, but is still positive. There is around $60 trillion dollars of government debt in the world. Nearly $17 trillion is at negative interest rates. If you bought a 10-year German bond today, your yield is -0.446%. In this example you would receive less money when the bond matures than when you paid for it. Our rates may be low, but at least they are positive!
The attraction of the largest economy with positive government debt rates is attracting others to buy our bonds. This pushes the price of the bonds up and the interest rate lower. Some are saying that we may have seen a peak in interest rates for a while. Other mature economies in the world are stagnating. Many have negative rates. All this is a negative drag on our rates. This has been one of the factors for the current yield curve.
Will the current inversion, flattening, or bowl in the rates point to a recession? Only time will tell. It does appear that there are arguments showing the factors we are currently experiencing seem different than the inversions of the past.