Why an Inverted Yield Curve can Predict a Recession? You are probably one of the contributors!
Since my article on May 23 (Yiu, 2019) informed you that the yield curve has been inverted, explained what it is, and asked the readers why it can accurately predict a recession, the signals of recession in the past 3 months are flooding the markets widely. Many countries, including the US, have started cutting interest rates, reflecting their beliefs of a coming recession. Furthermore, many countries, including Singapore, have reported negative GDP growths, indicating a higher probability of recession.
Firstly, a recession is defined as a long period of a significant decline in general economic activity, it is generally identified by a 2 successive quarters’ fall in GDP.
Secondly, “a yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.” (Chen, 2019)
Why an inverted yield curve can predict accurately a recession? And it takes about 6–18 months to materialize, and why it takes such a long time?
Since private consumption normally accounts for the biggest portion of GDP in developed economies, a reduction in consumption would result in a decline in trade and manufacturing activities. Keeping the number of population unchanged within a short period of time, the common reasons for a reduction of consumption is normally due to (1) an increase in borrowing cost, (2) a decrease in disposable income, and (3) a shock affecting the confidence of future incomes of the consumers.
All these three reasons are related to interest rate (i.e. yield rate). An increase in interest rate would immediately increase the borrowing cost, and would decrease the money available to spend. However, these changes should have an immediate effect, and would not take years to realize.
A more plausible explanation is that the prediction is itself a self-fulfilling prophecy. When there are shocks of the above three, people would spend less, borrow less, and save more. The market interest rate would thus have a decreasing tendency due to an increase in saving supply but a decreased in borrowing demand. Then, bond investors would switch to longer-term bonds so as to solicit the current interest rate for a longer time, because they expect that it will drop in the future.
Indeed, it is a very natural psychological response that makes strong economic sense. Then, when more and more bond investors put their savings into longer and longer terms of bonds, the over-supply of savings for longer-term bonds would further drive the interest rate down. Thus, the yield curve is flattened and then inverted.
It takes months to materialize such a change is because the three behaviors, namely, consumption, saving and borrowing behavior, would not change altogether. Highly levered households, for example, would normally cut their consumption much earlier and more than their counterparts, when the market signals a higher chance of recession or unemployment. Thus, a recession normally comes after reaching a very high debt-to-income level.
It’s a self-fulfilling prophecy because when someone starts spending less, borrowing less and saving more, an then the yield curve becomes flat or inverted, commentators and analysts start warning that a recession is coming. Then more people would join to spend less, borrow less and save more. It further bends the yield curve to even a deeper inversion.
Finally, when a sufficient number of people spend sufficiently less, borrow sufficiently less and save sufficiently more, the economy declines, i.e. a recession!
That is why Central Banks start cutting interest rates, as they are trying to urge more people to borrow more, spend more, and save less. Whether this contrarian approach can help save a recession is questionable, especially when governments would only bail out the riches. It also does not make any good senses to deal with too many debts by lending more debts.
Figure 1 shows you the US Treasury Yields. Comparing with the one in March that I showed you in Yiu (2019), the whole curve is not only inverting but also dropping very fast. Taking the 30-year yield rate as an example, it broke the 3% threshold in March, and it has just broken the 2% threshold on August 15. No wonder people are now talking about zero- and negative yield rates that have already been in existence in Europe, and the 50-year and 100-year bonds. (Harris and Barrett, 2019)
Harris, A. and Barrett, E. (2019) U.S. Weighs Selling 50- and 100-Year Bonds After Yields Plummet, Bloomberg, Aug 17. https://www.bloomberg.com/news/articles/2019-08-16/u-s-treasury-to-do-market-outreach-again-on-ultra-long-bonds-jzejo2qu
Chen, J. (2019) Yield Curve, Investopedia, Feb 5. https://www.investopedia.com/terms/y/yieldcurve.asp
Yiu, C.Y. (2019) Yield Curve is Inverted Today, Medium, Mar 23. https://medium.com/@edwardyiu/yield-curve-is-inverted-today-eb5e3c207749