The yield curve is touted as an important recession indicator. When long-term rates fall below short-term rates, the yield curve is inverted. Recessions typically follow in a year.
Conventional explanations for the yield curve concern investor confidence. Lower long-term rates suggest that investors anticipate a slowdown in the future. When slowdowns occur, the Fed responds by lowering interest rates. Anticipating this, investors lock in a lower long-term rate today. When the recession happens, and the Fed cuts rates, those ‘low’ long-term rates will become relatively high. In this sense, an inverted yield curve means worried investors. They are so worried that they no longer demand more interest to lock up their money for longer.
Economic confidence is vital for the economy. When consumers lack confidence, they save more, decreasing consumption. When businesses lack confidence, they invest less, decreasing real production. According to the conventional explanation, an inverted yield curve signals sentiments that bring about a recession.
Understanding banking offers an alternative explanation. Government bonds compete with banks for savings. In the hierarchy of investments, both represent safe ways of saving. Should banks offer higher interest rates, savings will go towards banks. This causes bond prices to decrease, causing their interest rates to rise. Bank interest rates and bond yields follow each other because of this competition. For example, a 3-year term deposit should pay the same interest as a 3-year bond.
A common belief is that banks make money by loaning it at higher rates. But why are they able to charge higher rates? Part of the reason is that it involves risk. But if that were the case, banks would make no money after accounting for bad loans which defaulted.
The missing factor is maturity transformation. Banks borrow at short-term rates and buy assets which pay at long-term rates. As short-term term rates are typically lower than long-term rates, banks make a profit by pocketing the difference. This is the fundamental source of their profit, not risk-taking. It is why banks borrow through short-term deposits and receive income through 30-year mortgages.
An inversion in the yield curve impairs the business model of banking. They rely on short-term rates being lower than long-term rates. An inversion entails the opposite conditions, where short-term rates are higher than long-term rates. Banks are strained, limiting their ability to loan. Decreased loans mean decreased consumption and investment, favouring a recession. In short, the effect is similar to higher interest rates. The difference is that what tightens the financial conditions is not the level of interest rates, but their discrepancy across time.
