Why You Should Be Ready for a Recession
With the prevalence of exaggerated shock journalism, it can be hard to tell where the economy is going on a day to day basis. Whenever things are slightly positive, newspapers will talk about a big boom. Whenever things are slightly negative, they instil a fear of global economic collapse. The truth, as usual, lies somewhere in between.
First, some basics about the treasury yield curve.
This is a theoretical yield curve for any maturing financial asset. US Treasury Bonds for example. In a normal yield curve — typically seen when the economy is expanding — the longer the time to maturity, the higher the yield. The curve can steepen or flatten over time as factors such as inflation expectations, monetary policy, and foreign economies all effect investor speculation, thus change the price of bonds through the law of supply and demand.
Over the past few years, the curve has appeared just as normal, with higher maturity bonds giving a higher yield. However, as shown by the yellow line in our graph, the current bond yield curve has changed. The 1-Month, 3-Month, and 1-Year bonds all yield higher than the longer term bonds up to the 10-Year bond. But why does this matter and what does this mean?
The important thing to understand is the relationship between a bond’s price and its yield. Without getting too technical, as bond prices rise, yields fall. This is because the coupon payment— the amount paid at a regular interval to the bond holder — is fixed at the purchase of the bond. Therefore, the higher the buying price of the bond, the lower the coupon rate is in comparison to the bond price.
Normal yield curves appear as they do because of the law of supply and demand. If investors believe the economy is going through a period of expansion, and economic outlook is good, they will choose to wait before purchasing long-term bonds as they could get a better deal in the future. The lower demand in the market for long-term bonds translates to a decrease in the bond price, which in turn means the coupon payment represents a higher proportion of the buying price of the bond, finally giving the bond a higher yield.
In order for short-term bond yields to grow and long-term bond yields to fall as we have seen recently, the opposite must be true. Investors are convinced that the long-term bond is the best deal that is going to be available for a number of years, due to negative economic outlook. This causes demand to increase, price to increase, coupon rate as a proportion of price to fall, then finally yield to fall.
The change in bond-yields we have observed recently means that investors are not optimistic about the US economic future, at least on the short-term. A yield curve inversion has a worryingly high accuracy as a leading indicator for a US recession. The last three times a yield curve inversion took place marked the oil price shock, the dotcom bubble, and the 2008 global financial crisis.
While it’s no crystal ball, and many economists have been trying to downplay the importance of the yield curve in a changed modern financial industry, the inversion should not be easily dismissed.
