Inverted yield curve and recessions

CIO Global Blog

16 Jul 2019

Historically, an inverted yield curve, where long-term US Treasury yields are lower than short-term rates, has been one of the most reliable indicators that a recession is on the way. Because of this, most models of recession probability include the shape of the yield curve, often as the single most important component. Yields on 10-year Treasuries fell below 3-month yields earlier this year, raising fears of recession. However, we still expect the economic recovery, now the longest in US history, to continue.

Examining previous periods where the yield curve was inverted, the proximate cause was usually the Federal Reserve raising interest rates. Typically, the Fed was hiking rates in an attempt to slow the economy down because inflation was too high, or the Fed was worried about overheating. In our view, there's nothing magical about this process—the Fed steps on the brakes and then the economy slows.

Inverted yield curve has signaled recession

Source: Bloomberg, UBS as of 16 July 2019

While it is true that the Fed has raised rates by quite a bit in the current cycle, including 100 basis points of hikes last year, rates are still very low from a historical perspective. The Fed estimates the neutral federal funds rate at 2.5%, while the actual rate is currently 2.4%. Even if you want to argue that the Fed's estimate is too high, it seems unlikely that 2.4% is so far above neutral that it makes a recession inevitable. Importantly, in this cycle, the Fed has never been trying to lift rates above neutral, and it seems perfectly willing to reverse course and cut rates to reduce downside risks.

Further, there are good reasons to think that the yield curve will be flatter on average than in the past. In an environment where the main problem for central banks is that inflation is stuck below their target, holders of long-maturity bonds will require less compensation for the risk that interest rates will have to be raised sharply in the future. The extremely low yields offered by non-US developed market bonds also help to put a cap on US yields. So it may turn out that one aspect of the "new normal" US economy is that when economic conditions are good, the yield curve is flat rather than upward sloping.

In our view, economic growth is slowing mainly because fiscal stimulus is fading, and the trade disputes are also having a negative effect. The main risk to the economy comes not from the flat yield curve, but from the possibility of further escalation on trade or another government shutdown after the current budget authority runs out on 30 September.

Author:

Brian Rose, Senior Economist Americas, UBS Financial Services Inc. (UBS FS)