Inverse yield curve - prophet or trigger of a US recession?

"We are currently experiencing a rare phenomenon: long-dated US government bonds offer a lower yield than short-dated ones. The yield curve has not been this inverted for more than 40 years," observes Philip Bold, Portfolio Manager at ETHENEA Independent Investors S.A. The difference between the yields of 10-year and 3-month US government bonds, for example, fell to an interim low of -133 basis points in March 2023. "This is - quite literally - not normal. A normal yield curve has a positive slope: The longer the maturity, the higher the yield," Bold classifies.

Inversion on the bond market as an indicator of a US recession

According to the portfolio manager, the fact that it is currently the other way round - i.e. inverse - indicates that the players on the bond market do not believe that the current high interest rate level will last in the long term. This is due to the expectation of a decline in inflation and/or a decline in economic growth. The possible cause in the expectation of a slowdown in economic development makes the inversion of the yield curve a much-observed indicator of an impending recession. "Since the 1960s, all recessions in the USA have been preceded by an inverted yield curve. So, the predictive power is very good," explains the portfolio manager.

Self-fulfilling prophecy? Inversion intensifies recessionary tendency

However, there is also a real economic causal aspect because the positive slope of the yield curve is the basis of the lending business: banks borrow money in the short term (and cheaply) in order to lend it in the long term (at higher interest rates) - the so-called maturity transformation. "An inverted yield curve makes long-term lending unattractive and slows credit growth and investment. These are classic characteristics of a recession," says the investment expert. In plain language, this means: "The bond market not only has prophetic strength, it is a self-fulfilling contributor to the recession."

The current inverse yield curve has already caused damage to the real economy, says ETHENEA portfolio manager Bold: "The recent bankruptcies of smaller US commercial banks have demonstrated this impressively. Whether the inversion is right this time too and a recession follows remains to be seen." A look at the past also shows: "In the past, there have been isolated cases of so-called 'false positives' - cases in which there was an inversion but not a subsequent recession.”

Philip Bold
Philip Bold

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Wim Heirbaut

Senior PR Consultant, Befirm

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