The business press recently generated a lot of comments about the Yield Curve. “The Yield Curve is inverting they cried,” and the specter of a recession in 2020 loomed over the White House. Trump immediately created an outcry by nominating two unqualified men to become members of the Federal Reserve Board. What in the name of the ghost of Christmas future is going on?
Some simple economics. The Yield is simply a technical term for the interest rate on a bond the day it is sold (that is, bond as in stocks and bonds, not 50 Shades of Grey bonds.) The interest rate or Yield of a bond is generated by the demand for that type of bond on any particular day. Just like stocks, in a modern economy, investors buy and sell millions of dollars worth of government and corporate bonds every day. The Yield Curve is simply the difference between the interest rate buyers receive when they buy a long-term, 10-year U.S. government bond and the interest rate when they buy a short-term, 3-month U.S. government bond.
In normal times, investors who buy 10-year bonds demand a higher interest rate than investors who buy 3-month bonds. This is because the value of a 10-year bond will go down if the rate of inflation rises and goes higher than the interest rate on the bond. As you can imagine, it is easier to predict the level of inflation and interest rates over the next three months than over the next ten years. The higher interest rate compensates the buyer for the amount of risk s/he is taking when buying a 10-year bond.
Falling Rates Predict a Recession
Of course, we do not live in normal times. The economy has grown very slowly since the 2008-2009 recession. As I predicted last year, even with Trump’s big tax cut for the rich, the economy only grew by 2.9% in 2018. This is about half the rate of expansions during good years in the 1950s and 1960s. In March, the Federal Reserve lowered its prediction for growth in 2019 to around 2% and said growth could be even slower in 2020.
As a result, bond investors now believe the Federal Reserve will have to lower the prime interest rate in 2020 or risk the economy falling into recession. While investors were buying 10-year bonds at 3.23% in October of 2018, by March 27 they were willing to purchase similar bonds at just 2.39%. On the same day, investors were buying 3-month bonds for 2.44%. Thus, the normal interest rate relationship, with longer term bonds paying out more interest than short term bonds was “inverted” or, in a layperson’s terms, reversed.
This is a very big deal. The unusual occurrence of short term rates that are higher than long term rates has correctly predicted every recession since the 1950s. For example, an inversion happened in 2006 before the 2007-2009 Financial Crisis. An important thing to remember is inversions predict recessions, not just slower growth. Since economies are complex and operate on their own momentum, by the time rates invert, fiddling with interest rates often can’t prevent an economic slump.
A Recession in 2020?
This explains President Trump’s sudden nomination of two men who are unqualified by most standards to be on the Federal Reserve Board. Their prime qualification is their willingness to pressure the Federal Reserve to immediately lower interest rates in a desperate attempt to stave off a recession in 2020. A recession next year could doom Trump’s re-election campaign.
What to Watch For
As of April 23, 2019, the 10-year rate has crawled back up to 2.59% while the 3-month rate stayed at 2.44%. So the Yield Curve has remained almost exactly inverted for over a month. The GDP growth rate estimate for Quarter 1 of 2019 will come out on Friday, April 26. If the number is below 2%, the 10-year rate will sink toward the 3-month rate, if growth is over 2%, then the rate might creep up and a recession becomes less likely.
Next: My next post will be about the underlying causes of our chronically slow economy.