Does the inversion of US yield curve hint at recession?

30 Mar 2022 , 09:44 AM

In the last few years, there has been a constant debate about the yield curve flattening or the yield curve inverting. Let us very quickly look at what it really means. To understand that, let us look at the US government bond market and how the US government borrows in the world’s largest bond market and how the yield curve gets created.

Dynamics of the US government bond markets

You would be surprised to know that the US bond markets alone is worth $23 trillion. That is nearly as large as the market cap of the NASDAQ and the overall GDP of the US. If you were to draw an analogy, the US government bond market is more than 15 times larger than the Indian G-Sec markets. Here is how the US government bond market is broken up.

Maturity of Bonds	Sub-Market in the US	Yield structure
Treasury Bills	1-month maturity to 1-year maturity	Technically, the yields on this segment are lowest
Government Notes	2-year maturity to 10-year maturities	Yields higher than treasuries but lower than bonds
Government Bonds	20-year maturity and 30-year maturities	Highest bond yields due to the higher maturity risk

The above table shows the break-up of the US government debt market. A typical yield curve is created by plotting the yields on all the above securities. For example, as you go towards longer maturities, the yields should be typically higher due to higher risk. For example, a 10 year bond is riskier than a 2-year bond and a 30-year bond is riskier than a 10 year bond. That is why the yield curve normally has an upward slope.

What does flattening or inversion of yield curve mean?

While theoretically the yield curve should be upward sloping, on occasions, the yield curve does becomes flat or negative sloping. When we talk of flattening or inversion of the yield curve, it is not about the entire yield curve flattening. The norm is to look at the spreads of specific maturities. Normally, 3 spreads are the most commonly used.

• 2-year yields versus 10-year yields (2/10)
• 5-year yields versus 30-year yields (5/30)
• 3-month yields versus 2-year yields

When you see something like the 2/10 spread in yield curve, it refers to the spread between yield on the 2-year treasury note and the 10 year treasury note. By plotting the 2/10 spread over a period of time, the flattening or inversion can be located.

But what does this flattening or inversion mean? When yield curve is upward sloping, it means banks can borrow lower and lend higher. That is a signal of a robust economy that is likely to continue to grow into the future. However, if the yield curve is flattening or inverting, it is a signal that the economy could be facing a downturn and could even be staring at a recession.

The US 2/10 spread enters flat territory

Chart Source: Reuters

This is the intraday chart (29th March) of the 2/10 yield chart or the spread between the 10-year yield and the 2-year yield. For the first time in more than 2 years, the yield spread turned briefly negative. While the opinion is divided on the efficacy of this signal in predicting recessions in the US economy, this metrics has been fairly accurate.

According to a Reuters report, since the year 1900, there have been a total of 28 instances of the 2/10 spread curve going into negative spread. Out of these 28 occasions, on 22 occasions the US economy slipped into a recession with a median time lag of around 22 months. The last time the 2/10 yield spread slipped into the negative was in 2019 and this was followed by the recession of 2020, although one can argue that this was due to the pandemic. However, a look at the last 20 years would confirm the view.

Since 1980, the 2/10 yield spread has gone below zero on 6 occasions, including the latest occasion on Tuesday 29th March. On the previous occasions in 1981, 1991, 2001, 2008 and 2019, the 2/10 yield spread falling below zero levels was followed by a recession. Of course, how long the recession actually lasts depends on the Fed action and other fiscal measures, but the risk is empirically for real.

Why is the yield curve inverting now?

The yield curve inversion in the US is being led by the extreme hawkishness shown by the US Federal Reserve. In its March FOMC meet, the Fed hiked the rates by 25 bps and promised to hike rates in each of the remaining 6 meetings in the calendar year 2022. However, with consumer inflation at 40-year highs, recent Fed noises have been extremely hawkish; even hinting at a 50 bps rate hike in the May-22 FOMC meeting.

This hawkishness resulted in yields on short-term U.S. government debt rising rapidly. However, the longer dated yields have been more languid and slower to move since the expectation is that in the longer run the higher rates could hurt growth. That explains why the yields have been less responsive in the longer end, resulting in flattening or inversion of the yield curve. In fact, the longer term concerns are best highlighted by the 5/30 yield spreads falling to -7 basis points.

What does yield curve flattening mean for India?

There are important takeaways for India from the flattening or inverting yield curve in the US. Since Indian yield curve is not yet well developed, the US yield curve is the best proxy. Here are some inferences.

a) Aggressive rate hikes are likely to bring down inflation in the short run but would negatively impact economic growth in the long run. It is a trade-off.

b) Unlike in a positive yield curve situation, banks will find their margins squeezed when the yield curve flattens or inverts. That would put pressure on bank profitability.

c) RBI policy will have to be more calibrated rather than just looking at monetary convergence. The focus on economic growth is unlikely to be given up.

This approach broadly conforms to what the RBI governor has been indicating of late. RBI may tread carefully on rate hikes, so as to protect long-term economic growth.