Reversal of the yield curve: the sign of recession causes panic

Friday afternoon, the yield curve is reversed, which, if you are a man half normal, sounds extremely boring, but he sent the financial press in all its states.

CNBC reported on a note from a Morgan Stanley client urging its clients to "defend themselves" with their investments because of a "key indicator of economic recession". A distinct, not so rebaduring segment of CNBC over the weekend, introduced a key Singapore Bank official urges not to panic about inverting the yield curve. But what is the right moment to panic? In particular, James Mackintosh's investment column on the Wall Street Journal noted that "the most reliable recession indicator in the market eventually blinks red," while Simon Moore at Forbes was more accurate, fixing the risk of inflation to exactly 30%.

This was quickly removed from the news cycle by breathtaking speculations on Robert Mueller's report on Trump and Russia, and then by the summary of the report itself, but it continues to be a topic in the financial media. And, realistically, you are more likely to be affected by the looming recession than by Russian hackers.

The truth, however, is that no one really knows if this unusual configuration of bond prices (this is what a reversal of the yield curve). really means that a recession is coming. But this is certainly not good news. And while you wait to see if an economic disaster occurs, you might as well know what the hell are the TV badysts talking about.

Yields and their curve, explained

All this conversion concerns fluctuations in the price of Treasury bonds, the inversion of the yield curve being the abbreviation of the prices of different types of bonds presenting themselves in an unusual way.

One of the ways in which a government or a company can borrow money is to sell a bond. A bond will have a face value (say $ 100) and, like any loan, will bear interest at a rate of interest (3%, for example). It will also have a maturity (say five years). A $ 100 bond with a 3% interest rate and a five-year term is comparable to a $ 100 loan at a 3% interest that must be repaid after five years. Another way of speaking would be to say that this five-year obligation returns 3 percent.

But bonds can also be bought and sold on secondary markets over time. So, someone could spend $ 110 to buy a bond with a par value of $ 100. The interest would always be calculated based on the initial face value, so the yield is lower now that the bond is more expensive.

The US government sells a lot of bonds of different maturities and people buy them and sell them all the time on secondary markets. As a result, each day you can calculate a whole range of different yields for Treasury bonds with different maturities. The Treasury Department even publishes this practical table:

Every day you can draw a graph showing the yields of different maturities and you get a curve – today's yield curve.

Normally, the curve goes up slightly.

More recently, this has tended to be a fairly flat curve – like a line. And in March, the curve has often had "inversion" moments, where longer maturities have lower returns than shorter ones. People in particular are paying attention to the relationship between the 10-year return and the three-month return because they are very widely traded bonds. And what triggered the wave of comments, is that on Friday, the 10-year yield fell below the three-month yield, a very rare and potentially disturbing event.

We do not care? It does not seem important

Ok, so here is the market. Normally, the yield curves are on an upward slope. All other things being equal, people charge higher interest rates for long-term loans because there are different types of loan risks (in the case of Treasury bonds, it is essentially inflationary risk). ) and the risks become riskier in the long run.

So for the curve to reverse, investors expect that something unusual will happen. Something that will lower future interest rates low enough to justify low long-term returns despite the risks. Something like the future collapse of the private sector investment demand that makes government borrowing cheap. Or something like a series of measures taken by the Federal Reserve to try to reduce interest rates and stimulate economic activity.

In other words, a future recession.

And indeed, the last three times the 10-year yield has fallen below the three-month return, a recession followed soon after.

That's what worries people. The bond market seems to predict a future recession.

Should I panic and sell everything?

No, do not do that.

If you come to the end of this explanatory, you will better understand what is happening on the financial markets than that of a typical person. But I promise you that sophisticated money managers with access to large reserves of cash and ultra-fast algorithms understand it better than you and I, and have already badimilated this information and carried out transactions on sophisticated models. . Stock prices and anything that may or may not be in your 401 (k) have already adjusted for these transactions.

It is, of course, quite possible that the smartest and wealthiest people on Wall Street are mistaken, however, and prices will fall further. But chances are, by reading Vox's explanations on your phone, you will not beat the professionals.

The only good way to plan a recession at the individual level is to try to make prudent financial choices, just as you would if you did not think a recession was likely in the short term.

But seriously, does that mean a recession is coming?

Look, it's not a well sign.

But if the empirical connection between past reversal events and recessions is real, it is also clear if you look at the graph that there is a lag in time. This means that there is nothing automatic in this process. And if the theoretical link between recessions and reversals is real, there are also other sets of future financial situations – such as a sudden spike in the value of the dollar – that could produce the same result.

Now, of course, a spike in the value of the dollar could actually provoke a recession by killing the exporting industries. Or it could be the sign of other problems (like a foreign bank panic) that themselves lead to a recession.

But – and this is the crucial part – these are issues that the Federal Reserve and other policymakers could address in order to keep the US economy out of recession. Indeed, Jay Powell, Chairman of the Federal Reserve, is aware of the situation in terms of yield curve, as well as hedge fund managers and sophisticated algorithmic traders. The Fed board and he himself have already decided to suspend interest rate hikes, worried about the weakness of their economy, and may try to take further steps to revive the economy. The last three times the yield curve has reversed, policymakers have failed to stop an impending recession, but that does not mean they will fail again.

The other important element to consider is that yield curves appear to be structurally stabilized over time in developed countries because of a combination of low stable inflation and higher population growth rates. low. If the curves are generally flatter, the inversion events may begin to occur from time to time due to more or less random transaction noise that does not necessarily signal much.

That said, although you can explain various reasons why last week's reversal Maybe not episode of an impending recession, the fact is that these reversal events were normally followed by recessions. Under these circumstances, rebaduring warnings can only be rebaduring – it's a distinct black cloud in an economy that has been giving us good news last year.