However, the inversion of the yield curve, by itself, does not imply much. The U.S. economy is not on a pre-set course from here on. Recessions occur with or without an inverted yield curve. It is important to understand a curve inversion represents the final stage of a gradual flattening process that takes place over several years. Why is the yield curve so important, and why has it historically been the single best predictor of recessions in the United States?
The yield curve, defined as the slope between 10-year Treasury yields and 3-month T-bill yields is a good proxy of monetary conditions, and a leading indicator of future credit conditions. As discussed in our credit cycle framework, the slope of the curve is indicative of the profit margin available to banks from borrowing at short maturities (i.e., bank deposits), and lending at longer-term maturities (plus a credit spread). When the yield curve flattens meaningfully, or even inverts, banks’ expected profit margins shrink, reducing their incentives to lend. As a result, financial conditions tighten on the margin and credit growth decelerates.
Yield curve flattening cycles have historically led to a tightening in lending standards by about one to two years, which coincides with the anecdote of its predictive power over the occurrence of recessions, by a similar lead time. Exhibit 1
The same logic can be applied to corporate bond markets. As corporate bond investors see a diminished yield pick-up from extending duration, they decrease their lending at longer-term maturities. As credit growth decelerates, the private sector becomes more vulnerable to a slowing economy.
If one agrees with this “supply of credit” perspective, then arguments about who the holders of U.S. Government debt are and why the flattening took place, are not that important. For example, during the last episode of yield curve inversion in 2006-2007, the narrative was that since a large percentage of U.S. Government debt was held by foreign central banks and reserve managers, the significance of an inverted yield curve had diminished. In hindsight, that argument was wrong. Today, a similar argument is being made as a result of large U.S. Federal Reserve (Fed) holdings of Treasuries. In our opinion, this argument remains weak, and the economic signal from the yield curve remains very relevant.
Key Indicators to Watch Going Forward
Historically, yield curve inversions have occurred with rising inflationary pressures in a slowing economy. Today the U.S. economy is already slowing, but the lack of inflation has allowed the Fed to stop raising rates and shift to a dovish stance. However, in our opinion, this dovish stance is not enough to prevent further deterioration. The inversion of the yield curve suggests the Fed needs to cut interest rates soon, re-steepen the yield curve, and prevent a tightening in lending standards.
We will monitor lending standards and credit growth going forward to confirm or refute the signal sent by the yield curve. If this episode of yield curve inversion will fail to see a recession, it needs the Fed to cut rates sooner and faster than the market expects. Otherwise, it will be another point in favour of the curve’s nearly impeccable track record.