The best predictor of a recession we have seen is the yield curve. While the yield curve may sound like something only economists would know about and discuss, it’s actually a surprisingly simple measure. In this post we’ll cover:
- What is the Yield Curve?
- What is an Inverted Yield Curve?
- What Does an Inverted Yield Curve Mean?
- How Does the Yield Curve Predict Recessions?
- What is the Yield Curve Saying Today?
- Recession Indicator: How Far Away Might the Next Recession Be?
- What to Do to Prepare?
- The Yield Curve and Gold
What is the Yield Curve?
The yield curve is simply a plot of the interest rates (or yields) of bonds with different maturation dates. That means the date the bonds expire and the principle is returned to the bond investor.
The yield curve is usually positive. Meaning the longer dated bonds have a higher interest rate than the shorter dated bonds.
Why is that?
Well if you lend someone money for a month versus someone else for 10 years, who would you want a higher rate of interest off? The 10 year loan of course, as there is a much higher risk in lending for the longer period.
Given you don’t know how market conditions – and therefore interest rates – might vary over such a long time.
Likewise bond investors expect a lower return when their money is tied up for a shorter period. Whereas they will want a higher yield to give them more return on a long-term investment.
This positive yield curve is important for banks and their profits. Banks “borrow short” and “lend long”. That is, banks take deposits off savers and pay them a lower interest rate and then issue mortgages for longer periods at higher rates. So banks rake in the profits with a wide positive spread. Which is exactly what they have been doing in recent years.
What is an Inverted Yield Curve?
Whereas an inverted yield curve occurs when the yields on short term bonds are higher than the yields on longer term bonds. This generally only happens with the likes of US Treasury note yields. That’s when yields on one-month, six-month or one-year Treasury bills are higher than yields on 10-year or 30-year Treasury bonds.
What Does an Inverted Yield Curve Mean?
Here is a really good explanation:
An inverted yield curve means that investors have little confidence in the economy. They would prefer to buy a 10-year Treasury note and tie up their money for ten years even though they receive a lower yield. That makes no logical sense. Investors typically expect a higher return on a long-term investment.
An inverted yield curve means investors believe they will make more by holding onto the longer-term bond than if they bought a short-term Treasury bill. That’s because they’d just have to turn around and reinvest that money in another bill. If they believe a recession is coming, they expect the value of the short-term bills to plummet sometime in the next year. That’s because the Federal Reserve usually lowers the fed funds rate when economic growth slows. Short-term Treasury bill yields track the fed funds rate.
So why does the yield curve invert? As investors flock to long-term Treasury bonds, the yield on those bonds lower. That’s because they are in demand, so they don’t need as high a yield to attract investors. The demand for short-term Treasury bills falls, so they need to pay a higher yield to attract investors. Eventually, the yield on short-term bills rises higher than the yield on long-term bonds, and the yield curve inverts.
During normal growth, the yield on a 30-year bond will be three points higher than a three-month bill. However, if investors believe that the economy will be slowing over the next couple of years, and then speeding up again in 10-20 years, they would prefer to tie up their money until then, rather than have to reinvest it sooner at much lower rates.Source.
An inverted yield curve is not great for the banks. So credit becomes tighter as they are more reluctant to lend.
How Does the Yield Curve Predict Recessions?
When an economy is booming, the central bank usually raises interest rates, with a view to slowing inflation and business activity. As a result the yield curve goes negative.
The opposite occurs when an economy has been in recession, or is coming out of a recession. Short term interest rates have been lowered, with the aim of increasing business activity.
So changes on in the yield curve can give an indication of economic conditions. The easiest way to track these changes is by plotting the spread between a short term and long term yield over time.
The chart below shows what is called the “2s10s spread”. This shows the difference between the 10-year US government treasury yield and the 2-year treasury yield. It is an easy way to track changes in the yield curve. When the 2s10s spread falls below 0, this provides a good indication of an impending recession. This chart is actually from back at the end of 2017.
“Historically, when the 2s10s spread falls into the negative territory, a recession tends to follow within a few months. At the same time when the 2s10s spread is below 0, the yield curve would invert.”
What is the Yield Curve Saying Today?
You can see in the chart above that the spread was declining leading into the end of 2017. This was due to the Fed funds rate (the US central bank interest rate) increases over the previous few years (see the bottom section of the chart for this). Thereby pushing up short term interest rates.
Now below is a live chart from the US Federal Reserve plotting the 2 year to 10 year Treasury bond spread.
If you zoom in you may be able to see that on the 14 August 2019, the spread dropped to just 0.1. That is the closing price. During the day it actually went negative and that garnered a lot of headlines.
The spread of 0.1 is the lowest since 6 June 2007.
After falling throughout 2018, the spread flattened out during the first half of 2019. However the fall now looks to have resumed.
The 2 and 10 year spread looks very close to dipping conclusively below zero. This will produce an inverted yield curve.
Recession Indicator: How Far Away Might the Next Recession Be?
If the above trend continues, then it could be any day now that the spread drops below zero into the danger zone. The 3 previous occasions the 2s10s spread went below zero, a recession followed soon after (red zones in the chart above or see grey areas in the live chart below).
On average a recession has followed 54 weeks after the yield curve inverted. But the time delay has varied greatly.
There were reports and warnings in December 2018 of the yield curve inverting. However this was referring to the spread between the 5 year and 3 year notes.
The big development over the past week or so is that yields on 10 year US government bonds have fallen below 3-month US Treasury bill rates. The more closely watched 10-2 year spread is still (just about) positive. But that doesn’t offer much reassurance since, at just 15bps, it is also now perilously close to inverting. Source.
The Yield Curve is Being Manipulated – So a Recession May Be Closer Than We Think
Mike Maloney explains in this very good video below that the short end of the yield curve – the 3 month bill rate – is being manipulated by the Fed. This interest rate would likely be much higher today if the Fed wasn’t buying these bills to keep the rate low. So we would actually have a more inverted curve already if it weren’t for this. Therefore a recession may be closer than we think.
What to Do to Prepare?
The flattening of the yield curve and the falling of the 2s10s spread indicate that we are in the final innings of the current cycle higher. Recently even the New Zealand Herald was starting to take notice with the headline: US recession risk grows as yield curve inverts.
This reliable recession indicator shows a recession is getting closer for the USA. New Zealand and the rest of the world will not escape unscathed. So now is the time to start building a cash position.
If your investments are mainly in the sharemarket or property it might also be a good time to consider diversifying into alternative assets such as gold and silver bullion too.
Particularly as these look to be at the start of the next cycle higher. Read more: Gold Cycles vs Property Cycles: When Will Gold Reach Peak Valuation?
What took place last week shows this is likely to be a good move in the long run. When the spread dropped briefly below zero, gold rose sharply while stocks worldwide sold off.
The Yield Curve and Gold and Silver Investing
So is the yield curve any help in determining when to buy gold or silver?
When the yield curve becomes inverted (i.e. 2s10s spreads drop below zero), and a recession is often about to happen, this can prompt people to prepare for an economic slowdown.
“Entrepreneurs start fighting for increasingly limited resources so they can fully fund their projects. Creditors will start to accept yields that are smaller. The upshot of all this is that gold and silver prices are likely to rise. People will be looking to invest in gold and silver as part of their preparation for an impending economic downturn.”Source.
However we’d also say that the correlation between the yield curve and gold is not strong. Gold can have many drivers affecting its price. But gold and silver look to be in the early stages of a bull market. Conversely the business cycle looks to be topping out. So with a recession likely around the corner, the coming changing of the yield curve may well be a bullish indicator for gold and silver too.
View the range of gold and silver available to purchase here.
Editors Note: Originally posted 20 March 2018. Updated 29 August 2018 added live 2 year to 10 year bond spread chart. Along with commentary on it and impending recession. Also updated 5 December 2018 and again on 3 April 2019 and 20 August 2019 to include latest 2 and 10 year spread numbers and further commentary.