Is Yield Curve a reliable economic indicator?

In this time of crisis, people are looking for different economic indicators for future investments and the economy of their own country at a global level. Everyone is afraid of the upcoming downfall in the economic activities and want to understand what’s next for them. The Yield Curve is one such graphical representation that helps answer a lot of questions about the economy at a global level.

What is a Yield Curve?

Yield curves track the relationship between interest rates and the maturity of bonds at a given time. It is a graphical representation of the interest rates on the debt for a range of maturities. The curve acts as an economic indicator for the investors and helps them analyze risk.

The slope of the curve helps to determine the risk in investment and understand better about how the financial market. There are different kinds of the yield curve which indicate distinct outcomes.

Normal curve

The most common curve is the normal curve. The curve shows a higher rate of interest rates for long time investments. For example, a 30-year bond will have a greater interest in comparison to a 10-year bond. This positively sloped curve is rational because the market will want greater returns for the risk they are putting in by investing for a longer period.

Flat curve

This curve represents the same amount of yield irrespective of the time of investment. This kind of curve is seen between the transitioning of the normal and inverted curve.

Inverted curve

An inverted yield curve appears when the long term yields fall below short term yields. It also indicates that people want money now and not later because during a recession demand falls. It is when long term investors realize that the short term bonds are more lucrative and the government might not be able to repay the said amount and therefore invest in short term bonds. This type of yield curve is an indicator of an economic downturn and indicates an upcoming recession.

The factors affecting the yield curve are inflation, economic growth, and interest rates offered by the banks. Inflation leads to an increase in interest rates and results in people buying short term yields. If the economic growth is good then people have more capital which means they invest more and this gives a steeper yield curve.

Okay till now we get a fair idea about what a yield curve is, but why is it important to have one?

The curve helps to forecast interest rates in the future and analyze risk in the investment. It gives a trade-off between maturity and yield. The curve helps understand the investors that the securities are temporarily underpriced or overpriced. Most importantly it helps in the prediction of an upcoming recession.

Talking about recessions, let’s see if this indicator has been useful in the past or not. Also, let us understand what the current yield curve is predicting for the future.

The Inverted Yield Curve predicted the recessions of 1970,1973,1980,1991, 2001, and also predicted the financial crisis of 2008 ( two years before it disrupted the economy).

The first hints of the inversion of the yield curve for the 2008 financial crisis were seen in December 2005.

The curve got worsened in 2006 and kept on inverted till June 2007. The Feds kept on reducing the rate. The rates at the end of 2008 were reduced to nearly zero by the Feds but unfortunately, the world had already entered its worst recession after the Great Depression. Many have the view that if the Fed would not have ignored the warning in 2005–2006 and come up with better policies the world would not have entered the recession.

Now let’s talk about the current situation which is not very likable either.

The yield curve started inversion in 2018 for the first time after the recession. The yield curve inversion in August 2019 predicted a recession in 2020. The 2020 inversion started in February.

The Feds say the chance of a recession in 35% but recently started to flatten and now it looks normal. So what does this mean? Is the model broken because everyone knows that we are going through a huge pandemic and an economic meltdown is staring in our eyes?

The man who invented the model, Campbell Harvey says that his model is working fine despite the fact we are in a global pandemic and economic situations do not seem favorable because the curve is indicating a recovery from the recession. According to him, recessions are short and recovery follows.

He also said that the model did not forecast the pandemic but it is intact and has a good track record. The inverted yield curve has predicted every recession after World War II. According to JP Morgan asset management, it has only given false alarm twice in 1965 and 1998.

Still, many people are not convinced and believe that the yield curve can not be trusted as the only indicator to assess an upcoming recession. Let’s see if this trusted method is correct about the upcoming recovery or gets crushed under this unpredictable pandemic which no one had seen coming.