The financial indicator is fabled but now fallibleby Paul Wallace / April 19, 2019 / Leave a comment
As prospects for the global economy darken the United States has remained a beacon of growth, helped by Donald Trump’s tax cuts. But a shadow is creeping over that light. The yield curve, a financial indicator with a reputation for predicting previous American recessions, is in the danger zone. Just how worried should we be?
The yield curve shows interest rates across the range of maturities—the periods over which money is borrowed—from short-term such as three months to long-term, typically ten years. The benchmark yield curve is for government debt (“Treasuries” in America) because it is the least risky. Typically it slopes upwards as the maturity of the Treasuries lengthens. Long rates are higher than short ones because investors generally demand a higher return for parking their money away for longer, exposing them among other things to the risk that it will melt away if inflation takes off.
But this “term premium,” or extra reward for long-term rather than short-term investing, does not hold at all times. And what economists have noted is that when the yield curve flattens and even inverts (so that short rates are higher than long ones, turning the term premium negative) that is an early warning of recession. Although the evidence for such a predictive property applies to the US, an American recession hurts economies around the world.
That’s why there’s anxiety now about the US where short rates are almost identical to 10-year rates. On Monday 15th April, rates on three-month Treasury bills were 2.43 per cent whereas yields on 10-year notes were 2.55 per cent. In late March the short rate was marginally higher than the long rate, inverting the yield curve.
On past form that indicates trouble ahead despite continuing evidence of momentum in the American economy, with a healthy increase in jobs of almost 200,000 in March. Although recoveries are not doomed to die of old age, another cause for disquiet is the sheer length of the recovery since the severe recession triggered by the financial crisis bottomed out in mid-2009. In July the upswing will become the longest ever on records stretching back to the mid-19th century.
Why should a flattening or even inverting yield curve spell trouble ahead? One reason is that it is picking up market…