Why everyone's so hung up on the recession red flag called 'the yield curve'

(Photo by Wang He/Getty Images)
  • The spread between three-month and 10-year US Treasury yields has inverted for the first time since 2007.
  • When that happens, it’s a bad sign for investors: Inversions have preceded all nine US recessions since 1955.

The bond market flashed a warning on Friday, sending stocks plummeting as investors fretted that this was surely a sign of recession.

When the interest yield on the 10-year US Treasury bond becomes the same or lower as the two-year bond, recessions have often followed.

The 10-year Treasury yield, which was already at a one-year low, declined further on Friday. This time, it crossed below the yield of the three-month bond.

That “inversion” was the first since 2007, Bloomberg said. The spread between the yields suggests that bond investors are more worried about getting a return in the short term than they are about the long term. That means they’re betting on a decline in US growth.

The yield curve inverted between the two- and 10-year yields before recessions in 1981, 1991, 2000, and 2008; an inversion has preceded all nine US recessions since 1955. Different sections of the yield curve have inverted at different times without a recession following, but major inversions are often a leading indicator of wider economic malaise or uncertainty.

The “curve” is a theoretical line that plots the difference between US Treasury yields based on their length to maturity. If that line goes below zero, the curve is said to invert.

A flat or negative yield curve suggests investors think that keeping your money in short-term bonds is more uncertain than bonds that pay off a decade from now. It suggests you’d be more certain about 2029 than 2021, which seems ridiculous when you think about it. So when the curve inverts, it signals something very risky is happening in the near-term asset markets.

The curve reacts to a lot of things – for instance, how investors feel about risk in other assets. If investors think the world is suddenly going to become very risky very soon, they will pile into bonds they think are safe. This has been evidenced by the massive sell-off in equities last Friday and Monday, with the US 10-year note trading up 0.4% as of 10:10 a.m. in London (6:10 a.m. ET).

Chinese debt. President Donald Trump’s trade war. Brexit. Italian debt. Global growth fears. Right now, much of the economic and political world looks as if it is composed entirely of uncertainty. It’s bad today. Surely we’ll have fixed the world in 2029?

So a flat curve could be signalling a bit of that. “This recent move has led Wall Street to question the Fed’s forecasts with futures indicating a greater than 50/50 chance that the Fed will cut rates in 2019,” according to Nick Giacoumakis, President and Founder of New England Investment and Retirement Group.

Investors will be closely watching the curve in the coming days to assess the likelihood of a US recession.

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