The Yield Curve and its relationship concerning slowdown and recession

The bond market is a safe, reliable investment for some or a dull market for others, yet not to argue is the one that makes up to headlines in any significant economic development. The bond market though indecipherable yet is packed with important indicators about the economy. This very bond market and its yield curve are also debatably are a simple model to forecast a recession. It is debatable as it is non-trivial to ignore the yield curve as it stores predictive records due to shifts in the economic landscape.

Nevertheless, it has to be dually noted that it is not proof that a recession is coming by itself. This paper explains the yield curve and its relationship concerning slowdown and recession and what to make of it.

Yield Curves

The Treasury Department prices a face value and interest rate for Treasurys, i.e., bonds. The interest rates are customarily lower than other investment instruments, as the bonds are considered a safe bet. Governments have a way to pay back their debts or negotiate over them.

When investors get nervous(typically due to a downfall in the market), they buy government bonds to assure their investments. The purchase of the bonds pushes its prices higher. Furthermore, when bond prices rise, the yields or the fixed interest rates investors collect on their bond investments fall. Hence, falling yields are indicators of the economic landscape.

Yield curves are basically plots of the bond interest rates of equal credit and different maturities. There are three variations to the form of the curves normal, inverted and flat. Normal yield curves are where longer-term maturity treasuries have higher yields than short-term maturity treasuries typically observed during economic expansion and on the contrary to normal are the downward sloping or inverted yield curves which are observed during to economic recession due to the fact explained in the above section relating to investors get nervous.

The argument between many economists and an argument this paper advocate is that the inverted yield curve is an indicator of a recession or slowdown. An inverted yield curve occurs when the yields on bonds with a shorter maturity are more high-priced than the yields on bonds that have a longer maturity. This should never be the case ideally as longer maturity duration treasuries are riskier than shorter and, therefore, should have high yields ideally. An inverted yield curve is an irregular situation that often signals an impending recession. If a yield curve inverts, it’s because investors have little certainty in the near-term economy. They demand more yield for short-term treasuries than for the long-term. They comprehend that the near-term is riskier than the distant future. They will do this only in one scenario, and that is if their intuitions say that the economy is going to get only worse in the near future.

What an Inverted Yield Curve Means

The U.S. Treasuries have three variations, each differing in 12 maturities. They are:

  • Treasury bills: these are the treasuries issued with maturities of 4, 8, 13, 26, and 52 weeks
  • Treasury notes: these are the treasuries that mature in 2, 3, 5, 7, or 10 years
  • Treasury bonds: these are the treasuries that mature in 20 and 30 years

As discussed before, If a yield curve inverts, it’s because investors have little certainty in the near-term economy. They demand more yield for short-term treasuries than for the long-term. They comprehend that the near-term is riskier than the distant future. They will only do this if they think the economy is getting worse in the near-term. If investors believe a recession is evident, their intuition is that the value of the short-term bills will plunge.

Federal Reserve lowers the Fed funds rate in the economic slowdown. Short-term treasuries, especially the bill, yields track the Fed funds rate. If investors believe a recession is evident, they’ll want a safe bet for the near-term. That decreases the demand for bills, increasing their yields up and inverting the curve.

How to read Yield Curve

The graph below is a very nice example of how to read the yield curves:

The graph below is the spread between the three months and the ten-year treasuries yields:

Analysis of the Inverted Yield Curve for Forecast of a past Recession

The analysis of the Treasuries yield curve inverted before the recessions of 1970, 1973, 1980, 1991, and 2001.

The yield curve also foretold the 2008 financial crisis by giving indicators as early as two years earlier. The first inversion of the yield curve was observed on Dec 22, 2005. with the argument that the Fed is worried about an asset bubble in the housing market. FED raised the fed funds rate in June 2004, and by Dec 13, it was 4.25%. This resulted in the yield on the two-year Treasury bill to 4.41% by Dec 30. On the contrary, the yield on the 10-year Treasury note didn’t increase as fast, hitting only 4.39%. The difference is called the yield spread, which was -0.02 points. That was the first inversion.

On Jan 31, 2006, the fed had increased the fed funds rate. The two-year bill yield increased to 4.54%. On the contrary, the 10-year yield was 4.53%, making the second inversion worsening till 2007. It was the subprime mortgage crisis, and the economy had entered the worst recession since the Great Depression in 2008.

The followings are the explanations given for why the yield curve’s inversion could be disregarded.

  • 1989 argument: The yield curve is inverted because commercial banks are buying longer-term Treasuries instead of lending to real estate. Result: the U.S. economy suffered a brief recession because of the oil price shock.
  • 2000 argument: The yield curve is inverted because the Clinton administration is running a budget surplus and no longer issuing long-maturity Treasuries. Result: the collapse of the dotcom bubble in 2001.
  • 2006 argument: The yield curve is inverted because a global savings glut is keeping longer-term bond yields pinned down — result: the deflating housing bubble and causing a global financial crisis in 2008.
  • 2019 argument: The yield curve is inverted because of the Fed’s market-distorting quantitative easing program, a jump in Treasury bill issuance, and low global interest rates. Result: unexplored

The relationship of yield curves and the recession is a debatable one, but Seth Carpenter, the chief US economist at UBS and a former senior Treasury and Federal Reserve official himself, quotes that

The yield curves of bond markets are indeed not trivial and have strong indicators embedded in it, which represents the economic landscape.

Works Cited

  1. “What Happens to Interest Rates During a Recession?” Investopedia, Investopedia, October 26, 2020, https://www.investopedia.com/ask/answers/102015/do-interest-rates-increase-during-recession.asp.
  2. Boston, Federal Reserve Bank Of. “Predicting Recessions Using the Yield Curve: The Role of the Stance of Monetary Policy.” Federal Reserve Bank of Boston, 3 Feb. 2020, www.bostonfed.org/publications/current-policy-perspectives/2020/predicting-recessions-using-the-yield-curve.aspx.
  3. Wigglesworth, Robin. “Has the Yield Curve Predicted the next US Downturn?” Financial Times, 4 Apr. 2019, www.ft.com/content/cf9eb29a-5220-11e9-9c76-bf4a0ce37d49.

Data Scientist by profession and just lazy by nature.

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