The yield curve inverted in March 2019 raising the prospects of recession according to historical models. Normally the U.S. yield curve for government debt is upward sloping. As bonds mature further into the future so the interest rate typically increases. With inversion that relationship goes into reverse. When the yield curve is inverted, you earn less interest on a long-term bond, than on the short-term one. Unfortunately, historically recession hasn't been far behind inversion.
However, there are a few different takes on yield curve inversion. We can assess its breadth, depth and chronology. Unfortunately, none of these examinations paint a rosy picture for the U.S. economy today. In addition, both interest rate futures and Fed policy makers themselves imply rate cuts may be on the cards.
How Broad Is The Inversion?
Below you can see what the yield curve looks like today. An inverted yield curve has a downward slope to it. Today's yield curve shows a distinct decline in rates on a 1 year to 10 year view. That's a pretty broad inversion. When the yield curve first inverted it mattered what your precise definition of inversion was, in terms of which bonds you picked to compare. Now, short term rates are generally above intermediate ones. This matters. The inversion is not a technical detail of specific bonds, but a broader feature of a large section of the curve.
How Deep Is The Inversion?
Regarding inversion's depth, the news is actually a little better. The inversion of the yield curve is currently shallow compared to history. Currently the spread between the 10 year and 3 month yields is -0.28%. That translates into broadly a 1 in 3 chance of recession within a year. That may sound like a lot but it's not actually too high when you consider that most economists would say there's at least a 10% to 20% chance that an unexpected shock could cause a recession in any given year, regardless of how things look in the U.S. right now. We'd need to see the gap between bond yields get about four times as big before the model signals that recession within a year is more likely than not per the chart below. It is the lack of a deep inversion that supplies most ammunition for those who think this time is different for the yield curve signal. However, it may also be a function of the low interest-rate environment globally.
The chart below shows the chance of recession related to the percentage point difference of the 3 month less the 10 year yield. Note that the model uses the average difference in yield over the quarter, not the difference on a single day.
To think of it another way, with the current level of inversion, if we held everything else constant, at a simplistic level, the Fed could cut rates twice and get the yield curve back to its traditional upward slope. As we'll see below, that's actually what the futures markets are starting to expect. As such maybe the current inversion will be gone by the end of 2019. By doing this the Fed would essentially be rolling the clock back to where their policy rate was in summer of 2018.
How Long Ago Did Inversion Occur?
The final thing to note about the yield curve model is that it aims to predict recession. In fact, the inversion typically happens a year or more before recession hits. On that score, the clock is ticking. We saw inversion in March of this year and so recession could now be 9 months away on a simplistic assessment. Of course, the model lacks real timing precision. Yet, historically it is the inversion that matters. In fact, sometimes the inversion reversed, but recession still came. So, in a sense, looking for what the bond market tells us now, is somewhat beside the point, since the recessionary 'trigger' for the basic model has already occurred.
The Prospects For A Cut
It's not just the term structure implying that the Fed may cut. The CME's FedWatch Tool implies that the debate at least among interest rate futures traders is no longer over what the Fed's next move will be. Indeed it's now how many cuts we'll see before the end of 2019. Two or three cuts appears to be the future's market current assessment. St Louis Fed chief Bullard also suggested that the Fed may cut rates "soon". Finally, the very inversion of the yield curve itself creates a challenge for banks. When banks earn more on their short-term lending, it's almost self-fulfilling that banks may redeploy capital and reduce longer term loans, cutting back on the sort of longer-term lending projects that fuel growth.
Now, of course, the Fed may cut rates without seeing a recession. A rate cut and a recession are not the same. Yet, that's been tough to pull off. The Fed hasn't been able to show that degree of finesse in the past, even though the equity markets appear to think they may. Historically the Fed has tended to cut rates too late, in retrospect. Maybe this time will be different. Unfortunately, history is not currently on the Fed's side.