The people who completely missed the housing bubble, the collapse of which sank the economy in 2008 and gave us the Great Recession, are again busy telling us about the next recession on the way. The latest item that they want us to be very worried about is an inversion of the yield curve. There has been an inversion of the yield curve before nearly every prior recession and we have never had an inversion of the yield curve without seeing a recession in the next two years.
If you have no idea what an inversion of the yield curve is, that probably means you’re a normal person with better things to do with your time. But for economists, and especially those who monitor financial markets closely, this can be a big deal.
An inverted yield curve refers to the relationship between shorter- and longer-term interest rates. Typically, a longer-term interest rate, say the interest rate you would get on a 30-year bond, is higher than what you would get from lending short-term, like buying a three-month Treasury bill.
The logic is that if you are locking up your money for a longer period of time, you have to be compensated with a higher interest rate. Therefore, it is generally true that as you get to longer durations, say a one-year bond compared to three-month bond, the interest rate rises. This relationship between interest rates and the duration of the loan is what is known as the “yield curve.”
We get an inverted yield curve when this pattern of higher interest rates associated with longer-term lending does not hold, as was at least briefly the case last week. For example, on Wednesday, March 27th, the interest rate on a three-month Treasury bill was 2.43 percent. The interest rate on a ten-year Treasury bond was just 2.38 percent, 0.05 percentage points lower. That meant that we had an inverted yield curve.
While this sort of inversion has historically been associated with a recession in the not too distant future, this is not quite a curse of an inverted yield curve story. Most recessions are brought on by the Federal Reserve Board raising the overnight federal funds rate (a very short-term interest rate), which is directly under its control. The Fed does this to slow the economy, ostensibly because it wants to keep the inflation rate from rising.
The higher short-term rate tends to also raise long-term interest rates, like car loans and mortgages, which are the rates that matter more for the economy. However, longer-term rates tend not to rise as much as the short-term rate. In a more typical economy, we might expect a 3.0 percentage point rise in the federal funds rate to be associated with a 1.0–2.0 percentage point rise in the ten-year Treasury bond rate.
We get an inversion in this story when the Fed goes too far, or at least investors in the bond market think it has gone too far. The Fed keeps raising the short-term rate, but investors in longer-term debt think that they see an end in sight to rate hikes and a reversal on the way. If the short-term rate is going to be falling to 2.0 percent or even lower in future months, then investors would welcome the possibility of locking in an interest rate like today’s 2.38 percent on ten-year bonds, even if it means foregoing a slighter higher short-term rate at the moment.
That’s pretty much the story we have today. Since December of 2015, the Fed has raised the federal funds rate from essentially zero to 2.5 percent. With little evidence of inflation and some signs of a weakening economy, many investors are betting that the Fed has stopped hiking rates and will soon be lowering them. This hardly means there we will necessarily be seeing a recession.
It is also worth noting that interest rates in the US are notably higher than in other countries, which do face a recession or near recession conditions. While the US ten-year Treasury bond pays 2.38 percent interest, a ten-year French bond pays just 0.31 percent. In the Netherlands the interest rate is 0.13 percent, and in Germany, you have to pay the government 0.07 percent annually to lend them money.
These extraordinarily low long-term interest rates in other countries puts downward pressure on interest rates here. Getting 2.38 percent interest on a ten-year Treasury bond may not sound very good by historical standards, but it is a lot better than having to pay the German government to borrow your money. This is another factor in our inverted yield curve.
Of course the weakness of foreign economies is bad news for the U.S. economy. Weakness in Europe, a weaker Chinese economy, and Canada possibly seeing the implosion of its housing bubble, means that trade will likely be a drag on growth in 2019 and probably 2020, as the trade deficit rises further. But, slower export growth is not going to be sufficient to push the U.S. economy into recession.
To be clear, the signals all point to a considerably weaker economy going forward. The Trump tax cut gave us a one-time boost. It was not the promised investment boom that lifted growth in 2018. Investment grew modestly, rather it was a story where the wealthy people — who were the main beneficiaries of the tax cut – spent much of the money they got either directly or indirectly as share buybacks and dividends.
This led to a jump in consumption in 2018, but with no further tax cuts on the horizon, we can assume that consumption will return to its modest growth path of pre-recession years. Investment has been weakening, but presumably will be a modest positive through the year. On the other hand, housing is being hit by higher interest rates and is likely to be a drag on growth.
The drag from housing and trade could well push growth below the 2.0 percent trend path we had been on through most of the recovery. The weakness can be amplified if the Republicans’ new found (post-tax cut) concern with deficits, combined with austerity minded Democrats, leads to cuts in federal spending.
However, with wages growing at a respectable pace, and job growth remaining healthy, we should see still see enough consumption demand to keep the economy moving forward. That means slower growth, but no recession.
One story we can rule out is a collapse of the corporate bond market leading to another 2008 financial crisis and recession. The New York Times has been running regular columns from former investment banker William Cohan telling us the corporate debt bubble story (here, here, and here).
As I’ve pointed out many times, the corporate debt market does not move the economy in the same way as the housing bubble did before 2008, and therefore its collapse cannot possibly lead to the same sort of downturn. The housing bubble was both directly moving the economy through an unprecedented boom in residential construction and indirectly through the wealth effect on consumption. People were borrowing against their homes and spending at an unprecedented rate.
When the bubble burst, residential construction collapsed, cutting more than 4.0 percentage points off of GDP (roughly $900 billion annually in today’s economy). The loss of housing wealth led to a plunge in consumption of at least 2 percent of GDP (another $420 billion in annual demand in the 2019 economy).
There is no way that even a major collapse of the corporate bond market could have anywhere near this effect. There is no investment boom, so the impact on investment of some companies being unable to issue bonds or otherwise borrow money is likely to be trivial.
The same applies to any secondary spillover on consumption. We are not now seeing any sort of consumption boom. In an extreme case, where we see a $1-$2 trillion plunge in the value of corporate debt, the ultimate impact on consumption is almost certain to be in the low tens of billions, perhaps a loss of 0.1 or 0.2 percent in annual demand. That is not the stuff of recessions.
Before the Great Recession the New York Times had problems finding people who understood the risks of bubbles to write for them. It seems to still have this problem.
Anyhow, the long and short here is that people need not spend time worrying about the curse of the inverted yield curve. At least not unless something else bad happens, there is not a recession on the horizon.
Enjoy the spring weather!