Recession? What Recession?

First, there is the yield curve:

Source: CNBC

This is a supposedly reliable indicator of recession. For those unfamiliar, a 30 year bond should pay a higher rate than a ten year bond, and even more so than a two year bond. This is to offset the inflation and investment risk of putting your money into something for three decades.

Generally, bonds work like this: higher demand for bonds causes higher prices which lowers yields, or rates of interest. If investors feel like the economy is doing well, and positioned to do even better, they’re not going to lock in an investment of 30 years. Why? If the economy is expanding robustly, the federal reserve may raise interest rates to offset inflation. This in turn raises the interest rate for bonds. If a bond is paying 2% today, but the economy is skyrocketing and I know the rate will eventually rise to 4%, why would I invest today, especially for such a long time horizon?

For bonds, interest rates and prices work inversely. If no one wants a particular bond on the market, the interest will rise to attract more investors. If a lot of people want a particular bond on the market, say a 10 year bond, the price will rise(simple supply and demand) and the interest rate the bond pays will fall. If bond investors think that the economy is due for a recession, they want to lock in bond yields now, because they anticipate they will fall in the near future (when the economy contract the Fed lowers rates to spur investment among other things). This causes those bond prices to rise, and their yields to fall.

There is your crash course on bonds. Now we can return to the chart. The red and green lines, representing 2 and 10 year bonds respectively, have inverted. In the world of bonds, this means that generally investors expect a downturn, and they are locking in the current rate for ten years, rather than waiting-and-seeing by investing in the 2 year bond rate. The dynamic between the 10 and 2 year bond I have a tentative grasp on. The same dynamic between the 30 year and the 3 month I cannot explain. The CNBC article notes however:

“The 30-year bond yielded 1.955% and was poised to close below the 3-month bill yield for the first time since 2007.”

Certainly you can expect that the 30 year investor and the 3 month investor are completely different. I gather that this relationship isn’t quite as important as the 2 to 10 year relationship as a predictor of economic productivity, but taken into historical context and just basic math, this should be a definite signal. I can earn a higher interest rate investing in government bonds for three months than I can for 30 years. Sure, there are fewer annual coupons I will receive(interest payments) but I could just as easily offset that will a higher initial investment.

As an informed consumer you should be rightly asking, “well, how accurate is the inverted yield curve as described above, at predicting recession?” Unfortunately, the 2 and 10 year bond yield curve has been somewhat of a “gold standard” at predicting recession:

The black line represents when the 10 year bond yield dips below the 2 year bond yield. The grey vertical bars represent recession. Incidentally, I have followed up with the Chicago Fed to determine why, if the reported yield curves have inverted, is the spread still represented positively on the chart above. Details to follow…

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