What is the fuss over the yield curve inverting?

Shrey Srivastava,  London 18/02/19

LSE SE Business and Finance Guild, London School of Economics 

On the first week of December 2018, major US stock indices have experienced increases in volatility, corresponding to fear that the yield curve is inverting. The yield curve, in this case, can be defined as a curve whereby the yield of US bonds is plotted against their time to maturity. In the current case, the main issue is that the spread between the two year and ten-year maturity bonds is becoming dangerously low; in fact, it hasn’t been this low since the Great Recession. Normally, the yield on long-term debt is higher than that on short-term debt because longer maturities indicate higher uncertainty about future economic events. Hence, yields on long-term debt are higher as a type of “risk premium”, and also to mitigate the risk of future inflation. When the yield curve inverts, however, the yield on short term debt is, in fact, higher than that on long term debt, reflecting anticipated future negative economic events (such as a recession). This will of course also affect stocks, explaining the recent dive in stock prices and why some US indices are at or close to entering correction territory.

Looking at history, it would make sense to be worried about the inverted yield curve: it has been an excellent predictor of previous recessions. Research from the San Francisco Fed has indicated that every recession of the last 60 years has been predicted by an inverted yield curve, with only one false positive that occurred when an economic slowdown (but not an official recession) occurred in the mid-1960s. This explains why any move towards an inverted yield curve has markets so spooked; in a subject dominated by assumptions and uncertainty, it is one of the only indicators of a recession that consistently appears to hold true. There are also theoretical reasons for an inverted yield curve being bad for economic growth (and therefore domestic aggregate demand and stock prices). A flattening yield curve makes lending less profitable for retail banks, as their business is essentially to borrow at short term rates and lend at long term rates. If the yield curve then inverts, this becomes an unprofitable business and thus restricts the flow of credit in the US economy, reducing demand for assets such as stocks, and thus potentially leading to a decrease in their prices.

​Although from this perspective the yield curve inverting is very troubling news for stocks, it remains to be seen whether it will actually invert; the recent moves in US stocks based on this have thus been largely down to speculation. In actuality, the yield curve for US government debt has been on a flattening trend since 2013, so recent events may not be as indicative of a sudden recession as previously thought. The moral, then, is that the flattening yield curve is indeed hugely troubling news for US stocks. However, before making further investment decisions or altering the balance of a portfolio it may be prudent to see if there is actually any substance to the yield curve inversion, or if it is just hype. 

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