August 28, 2019 800 PM
You may have come across the “inverted yield curve,” which most certainly does notgo trippingly on the tongue. It used to be an esoteric topic, something spoken about only by monetary geeks and then only in the privacy of their economic bedrooms. Today, even the president rails on about it. No wonder. The inverted yield curve is a good leading indicator of a recession, and a recession would not help the president’s election chances next year.
The yield curve is simple. Say you want to borrow money from me. If you want it for three months, as a lender I’m willing to take low interest — what it “yields” to the borrower. It’s a short period, so it’s easier for me to make an informed guess about inflation and also about what else I could make off the money if I don’t lend it to you. But if you want it for five, 10 or 30 years? Then I need more interest for the extra uncertainty in tying up my money much longer. Normally, the interest you demand curves upward the longer the time you’re lending for.
There are many lenders and borrowers, so there are many yield curves. The news today is about the specific curve for U.S. government borrowing. The government, through the Treasury Department, borrows money to finance its operations by selling bonds and bills, called generally “Treasuries.” The Treasury borrows by selling Treasuries for periods as short as one month and as long as 30 years. When the period is over, the debt “matures,” and the lender is repaid the amount lent. Lenders to the US want the same thing you and I do: to be paid more to lend out their money for longer periods.
Here is what a normal yield curve looks like for US Treasury debt. Interest rates are on the left side. The time of the Treasury bond or bill is on the bottom, from one month to 30 years. As you’d expect, near-term rates are lower. Longer-term rates are higher. See how rates rise upwards and to the right? This is normal. All good.
But sometimes things go catawampus. This attracted the attention of two New York Federal Reserve Bank economists, who in 1996 published a breakthrough paper, “The Yield Curve as a Predictor of U.S. Recessions.” The idea put broadly was that if the normally upward sloping curve (above) went catawampus and sloped downward, a recession seemed to follow. Here is a generally downward sloping— “inverted”—yield curve:
Here, for reasons hotly debated, lenders demand higher interest for short-term loans than longer term. Today, buyers of US Treasuries require 1.98% to loan for three months but a lower 1.49% to lend for 10 years! Why would anyone take less interest for a longer loan? It makes no sense. (I spent an hour on the phone with someone who has considered this seriously for several decades, and we didn’t get anywhere.)
Regardless, the track record of the inverted yield curve as a leading indicator of a recession is excellent going back to 1959. While we cannot say that a recession is guaranteed, the odds have gone up. The yield curve is hardly the only thing upside down right now, but it may be the only rational one. Which is why our president is very much afraid of it.
Tom Jacobs is a partner with Huckleberry Capital Management, a boutique investment advisory firm serving clients in 25 states and 3 foreign countries from offices in Marfa, TX, Silicon Valley, CA, and Asheville, NC. You may contact him at 432-386-0488 and tom@investhuckleberry.com.
