An Inverted Yield Curve: Should We Be Worried?

5th December 2018 Off By binary
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A NYT article on the stock market’s plunge also noted that yield curve, defined as the gap between the interest rate on 10-year Treasury bonds and two-year notes, is close to being inverted. The interest rate on 10-year bonds was just 0.12 percentage points higher than the interest rate on 2-year notes. The piece points out that an inverted yield curve has historically been associated with a recession in the near future.

While I would not rule out a recession (we will have another recession some day), I am less impressed by this signal than the NYT. The longer term rates tend to follow the expected path of the short-term rate with a longer yield providing a greater premium since the holder of a long-term bond suffers a substantial capital loss if the price goes down.

For example, if I’m holding a 10-year Treasury bond and the interest rate increases from 3.0 percent to 4.0 percent in a relatively short period of time, the price would fall by close to 8.0 percent. To cover that risk, I will want a premium over the short-term rate. The same logic applies to a 2-year note, except that the potential loss from a rise in interest rates is much smaller so the necessary premium is much smaller.

However the risk in this story is that the Federal Reserve Board will raise interest rates. Currently the federal funds rate is at 2.25 percent. While there is a good chance the Fed will raise rates by 0.25 percentage points at its meeting this month, Fed Chair Jerome Powell has made it clear that he thinks we are near the end of a cycle of rising rates. For this reason, holders of longer term debt have less reason to fear that short-term rates will rise much from their current level. Therefore, they are not demanding large risk premiums.

Historically we have reached this point where investors no longer saw much risk of further rate hikes after a period of aggressive rate increases by the Fed. In 1989 the peak of the federal funds rate was almost 4.0 percentage points above its cyclical low. In the mid-1970s it was more than 8.0 percentage points, and in 1980 the federal funds rate peaked more than 14.0 percentage points above the low for the cycle. 

When the Fed engages in an aggressive round of rate hikes, it is reasonable to bet we will see a recession. In this case, the Fed has been much more modest in its rate increases. While there is little doubt that the rate hikes are having an effect in slowing the economy — housing has been hit hard and the rise in the dollar is causing the trade deficit to rise — these sources of weakness do not seem sufficient to throw the economy into a recession, even if the yield curve does invert. 

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