For a long time now, the word “recession” has been constantly ringing in our ears. Whether it may be Fox, CNN, or the Wall Street Journal, the possibility of the United States economy entering a recession has dominated all sources of media. The tensions have been high, even though an traditional full-scale economic downfall hasn’t occurred. So what exactly has caused all this panic? The answer: an inverted yield curve graph.
Treasury Bonds
The idea that the government runs out of money is shocking, but it happens quite often. Just like the rest of us, the government needs loans when their budget isn’t properly managed. In an effort to raise money, the government holds an auction in which investors from around the world can invest in securities called Treasury Bonds. These bonds are a loan from the investor to the government for a specific period of time, which can range from one month to as long as 30 years. When the bond matures, the government pays the investor the loan back along with interest.
There are three types of Treasury securities that can be invested in: bills, notes, and bonds. The main difference between these securities is their maturity terms. Bills are securities whose maturation terms are anywhere from a month to a year. Notes mature between 2 years and 10 years, while bonds mature between 20 years and 30 years.
Yield Curves
A yield curve graph showcases the relationship between the yield, or interest rate, of a bond and its maturity term. Typically, the yield curve is an upward-sloping graph in which the bonds with the shortest maturity term have the lowest interest; as the term length increases, so do the interest rates.
Encyclopedia Britannica (APA citation)
Treasury bonds with a longer maturity term are considered more risky as inflation can cause the interest rate on long-term bonds to decrease, causing the investor to make less profit off the security. Hence, the compensation long-term investors receive for their risk is higher interest rates for notes and bonds than those of bills.
However, the graph above depicts the yield curve only when the economy is in a stable position. Inflation has been at a record high for the past year and as a result, investors have lost trust in the economy. In an effort to revive consumer activity in the market, the Federal Reserve Board has been increasing interest rates for short-term bonds. Investors will be more convinced to buy these securities when they yield a larger profit in a shorter amount of time as well. Consequently, the interest rates for long-term bonds have drastically fallen as their demand has slowed due to the more attractive option of Treasury bills. When this occurs, an inverted yield curve is created.
Investopedia
Thankfully, an inverted yield curve does not mean that all hope is lost for long-term investors. The FED reconvenes every six months to discuss interest rates; when the economy starts to show recovery from inflation, interest rates for short term investments will be cut and naturally, the yield curve will return to its original shape.
Curves and Recession
The core purpose of a yield curve is to hint at a possible recession. Experts use the graphs to calculate yield spread, the difference in yields between two Treasury securities with varying maturity terms. Yield spread is usually calculated by subtracting the yield of a 2 year note from the yield of a 10 year note. The graph below showcases the yield spreads over the past few decades.
Bloomberg
When the spread touches 0, it means that the yields for the 2 year bill and the 10 year note have become the same; as a result, the probability of a recession occurring becomes likely. History has validated this theory a myriad of times, as shown in the graph. A spread of zero preceded every recession that has occurred since 1977. Still, there are some economists who are still skeptical about the yield curve’s ability to predict a recession. Is this time any different? Or will history prevail again? Only time will tell.
Current Conditions & Future Predictions
Fortunately, the economy seems to be recovering without experiencing the precedent of recession seen in years past. Interest rates are slowly decreasing, with the yield on the two year note having fallen by 0.15% and the 10 year note having fallen by 0.12%. The yield spread is currently 0.88, a decrease of almost 1.1 percentage points from late June. This improvement does not mean that the economy has entered a safe zone, however. A change in one economic factor, such as the job market, is enough for the economy to plunge into recession. Hence, investors and consumers should continue to be cautious when making fiscal decisions in order to be monetarily sound in the case of economic collapse.
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