Bond markets have sent a warning signal about the US economy’s growth prospects, just as central banks try to combat rising inflation by raising interest rates and scaling back their open market operations.
The market for US government bonds has historically been a good predictor of whether a recession in the US is around the corner. With more than half of the global reserve currency being denominated in the US dollar, it is important to consider the yield curve of the US government.
The yield curve depicts the interest rates at which governments can borrow money over various periods. Essentially, the yield curve is a graph in which the yield on fixed-income securities is plotted versus the time it takes for these securities to mature. These periods of maturities can be for a few months, a few years or even a few decades. Yields should be lower for shorter maturity bonds and increase as maturity increases. Therefore, the yield curve is graphed to show an upward sloping curve, whereby a higher yield is earned from lending money for longer periods.
Shorter-term yields tend to represent what investors believe will happen to central bank policies and inflation over a short-time period. Longer-dated maturities represent investors’ best guess at where inflation, growth and interest rates are headed over the medium to long term.
When economic growth slows, inflation is below 2% and the central bank is expected to lower rates, rates on 10 and 30-year bonds often fall towards those of shorter maturities, such as those maturing over 2 years and vice versa if inflation is above 2% and the central bank is expected to raise rates.
As such, the yield curve starts to flatten and become what is referred to as inverted. This becomes a recessionary signal. For the past 50 years, the yield curve inversion has preceded every downturn in US economic history. The graph below shows the difference in yield between the 2 and 10-year US government bonds since 2006. Any point below the red line signals an inverted yield curve. Both times the yield curve has inverted, a recession has followed.
Why has this happened? Russia’s invasion of Ukraine has sent commodity prices significantly upwards, adding more inflationary pressure on top of supply constraints which was a large driver of inflation even before the invasion began. Higher energy costs are expected to deplete growth rates. It could be said that the inversion of the curve has implications for some investors that the short-term outlook does not look good.
Another reason is interest rate expectations. The Federal Reserve has already raised rates twice this year and is expected to raise them more this year. Some analysts predict that the US base rate could be above 2% by the end of this year (the range is currently 0.75% to 1%). If central banks raise their interest rates, the market will want some compensation for holding government bonds instead of cash in a bank account via a higher yield on bonds.
We should note though that despite the success of an inverted US government bond yield curve in predicting a recession in the future, it doesn’t provide details about when the recession will happen or the size of the recession.
Written by Artem Dubas
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