14 December 2018
Bob Cunneen, Senior Economist and Portfolio Specialist
Source: Federal Reserve Bank of St Louis
Investors have become alarmed that the US yield curve indicates that a recession is coming. The ‘yield curve’ is the gap between long-term and short-term interest rates (red line). Currently the US yield curve is barely positive at only 0.15%, if one uses the gap between the US government ten year bond yield and the two year bond yield.
A falling yield curve is a worry. When the bond market pushes longer dated bond yields towards or below shorter term yields, this can signal that financial conditions are stressful and economic activity is set to weaken. Remarkably, a negative US yield curve has a great track record of predicting US recessions. In the last three US recessions starting in 1990, 2001 and 2007, a negative yield curve appeared before US economic activity slumped (blue line).
However US recessions have occurred with a considerable time lag after the yield curve goes negative. The time lag has varied between 13 and 22 months for the last three recessions. So the yield curve is a warning sign but not a clock. The potential causes and catalysts for the next US recession may still be in the making. Possibilities include the US central bank raising interest rates too high, the President’s impeachment, a global conflict or an energy crisis. Hence we cannot exactly forecast the timing of the next recession simply by the yield curve. All the yield curve signifies is that there is an economic and financial cycle that investors need to be wary of when looking at expected returns and risks.
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