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Beware, Yield curve inversions ahead! Stokes fears of economic recession

Author: Sunnam Bharath Kumar/Wednesday, August 28, 2019/Categories: Exclusive

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Beware, Yield curve inversions ahead! Stokes fears of economic recession

Among the list of major indicators, yield curve is a big factor to predict the economic recession. The yield on a 10-year US treasury bond fell below the yield on a 2-year bond on August 14, 2019, for the first time post global recession in 2008-09. The yield difference between the long-term maturity and short-term maturity of the same investment grade bonds is known as yield curve. Generally, investors demand high yield for a longer maturity as there is price risk attached to it while the shorter maturity bonds with similar risk carry less yield compared with the longer maturity. Hence, the difference between a 10-year and a 2-year government security will be mostly positive.

In contrast, when an investor wants less yield for longer maturity than shorter maturity bond, the yield curve falls into negative territory. This is called yield curve inversion. The investors demand high yield for short maturity as they are less confident about the near term economic future and are concerned about the headwinds to the economy in the next couple of years. A higher demand for long term bonds while the investor shifts from a short term assets to long term assets will result in the fall of long term yields. Bond yield and price are inversely related.

The spread between widely watched benchmark US 10 year and 2 year yield inverted recently and the 10 year and 90 day Treasury Bill has been trailing in the negative zone since May 2019. Slowdown in the global economic growth, ultra low inflation and growing trade tensions have resulted in an inverted yield curve. An increase in supply of negative or sub-zero yielding long term bonds in the recent past is another reason for a fall in long-term yields.

Historically, data indicates that an inverted yield curve is generally followed by an economic recession. What not so worrying about the current yield curve inversion is that it came when the IMF anticipates an economic growth of 3.2% in 2019 and more importantly it is expected to rebound to 3.5% in 2020. A strong US consumer spending and continuously rising equity markets rules out the possibility of a recession as indicated by yield curves. Enormous spending plans laid down by the Asian and European banks would push the recession fears away for now. The current yield curve inversion should not make you worried if it’s a result of shift in investment form short-term maturity to long-term but one should be cautious if the inversion coincides with the sharp fall in the GDP growth. (The author is Fundamental Research Analyst, Karvy Forex & Currencies Pvt. Ltd)

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