The yield curve is bad shape, forecasting recession.
by Henry Hittle
Staff Stock Broker
You may have heard your friends in Gabelli or those majoring in economics talking about the “yield curve inversion,” and perhaps simultaneously panicking about their Robinhood or E*Trade accounts. So the question you are surely asking is “what exactly is the yield curve?” A yield curve is often used by economists and investors as an indication of where the economy is heading. It is associated with a financial instrument known as Treasury bonds.
As defined by Investopedia, a Treasury bond is a “government debt security that earns interest until maturity.” In layman’s terms, a Treasury bond is a loan an investor gives to the U.S. government under certain terms. The two main terms of the loan are the interest rate (or yield), the amount paid to the investor each year, and the date of maturity, the time at which the government must pay back the principal loan in full. U.S. T-bonds, as they are also called, are known among investors to be one of the safest investments in the world due to their fixed interest rates, tax exemptions, and most importantly their backing by the U.S. Federal Government.
The characteristic that makes bonds so important as an economic indicator is their interest rates. Interest rates are determined by the demand for a bond. Demand fluctuates based on the perceived risk for investors. Each different term bond has its own interest rate, such as 2-year, 10-year, 20-year or even 30-year bonds. Typically, the longer the term, the higher the risk it won’t be repaid, and thus higher interest rates (or yields) for investors. The most commonly analyzed yield curve the “10-2 yield spread,” the difference between the interest rates of 2-year bonds and 10-year bonds. When the yield on a 2-year bond becomes higher than that of a 10-year bond, alarm bells all over Wall Street and Hughes Hall begin to sound. This is a yield curve inversion. The reason it is so concerning is that it signals to the public that investors have a belief that within a short period of time, the economy may not be strong enough that their bond can be repaid, signaling an impending recession.
One might ask, why is some number determined by Wall Street important enough to predict our financial doom? After all, not all finance majors can be economic oracles. But believe it or not, there is some historical precedent for it. In 2008, the global economy was hit with the worst economic downturn since the Great Depression. When we look at the yield curve prior to the crash, we can see that the yields inverted just 17 months earlier. In the 2001 “Dot-com bubble” burst, an inversion took place just 12 months earlier. In fact, every recession in the last 50 years has unfailingly come at least one year after an inversion.
The question is, when would a recession happen? In an August survey conducted by the National Association for Business Economics, 75% of economists believed there would be a recession in 2021. To make matters worse, the U.S.-China Trade War continues to intensify, while the markets seem to go ballistic with every one of President Trump’s famous profound tweets. Who’s to say when or even if a recession will happen.
While indications may point towards an uncertain future, it is important for anyone concerned about the direction of the economy to remember that ours has bounced back from every recession, and that in the long run, markets will always grow in value. Rest easy, my Gabelli friends. Your financial future remains bright and green.