Small inversions do not mean big risks

Posted by: Paul Donovan

31 May 2019
  • The US ten-year yield is below the three-month interest rate. Some investors fear that this "inversion" predicts a recession.
  • In the 1970s, inflation was the main driver of bond yields. In the 1970s, the economic cycle was the main driver of inflation. If bond investors expected the economy to slow, they expected inflation to fall. If bond investors expected inflation to fall, they would drive down bond yields. If a recession was expected, the yield curve would logically invert.
  • In today's economy neither condition is necessarily true. The real yield is a more important driver of bond yields (as inflation numbers are smaller). The economic cycle is less important as a driver of inflation. If bond investors expect the economy to slow, inflation may or may not fall. If inflation falls, the bond yield may or may not go down.
  • The yield curve recession "relationship" never worked well outside the US. If bond markets could reliably predict recessions, they should be able to do so everywhere.
  • A very big yield curve inversion will signal a high recession risk. An inversion of 150bps says something is wrong with the economy. Today's inversion is too small to reliably signal a recession.

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