Yield curve inversion has often been seen as a warning sign for economic recessions. Today, Canada’s yield curve remains inverted – but does that necessarily mean we’re headed for a downturn?
To better understand the concept of yield curve inversion (the relationship between the 3-month and 10-year treasury bond yield), we must examine its origins, implications for the economy, and why the yield curve matters to investors and policymakers.
Origins of the 10-3 Yield Curve Inversion:
Professor Cam Harvey wrote his Ph.D. dissertation on the 10-3 yield curve inversion in 1986. Driven by his internship experience and the limitations of existing forecasting models, Harvey explored the relationship between bond yields and future economic conditions. He found that the spread between the 10-year and 3-month treasury bond yields exhibited valuable information about the economy’s health. Moreover, the inversion must last at least 3 months in order for it to be meaningful.
Why Is the 10-2 Yield Curve Always Mentioned?
While the 10-3 yield curve inversion has shown a strong historical track record, some experts have shifted towards the 10-2 inversion, which would refer to the relationship between 10-year and 2-year treasury bonds.
However, Professor Harvey emphasises the importance of maintaining the 10-3 model due to its solid theoretical foundation and consistent historical performance. He argues against switching models solely for the sake of fitting the data better, especially when the 10-3 model has successfully predicted recessions without false signals. His original thesis was that since GDP is measured quarterly, we should use a corresponding measure when building the framework. It’s important to note that the 10-2 yield curve did give a false signal in 1998, whereas the 10-year and 3-month has not ever given a false signal – not yet, anyway.
Understanding Yield Curve Inversion:
Yield curve inversion refers to when short-term interest rates become higher than long-term interest rates. The 10-3 yield curve inversion occurs when the yield on the 10-year treasury bond falls below the yield on the 3-month treasury bill. This inversion is considered significant because historically it has preceded economic recessions.
Implications for the Economy:
The yield curve inversion, particularly the 10-3 inversion, is often viewed as a potential warning sign for an upcoming recession. When investors and market participants expect economic conditions to deteriorate, they tend to seek safer investments, such as long-term bonds. This increased demand drives down long-term bond yields, causing the yield curve to flatten or invert. The phenomenon reflects market expectations of future economic weakness.
Analyzing the Recent Yield Curve Inversion:
At the end of 2022, the 10-3 yield curve inverted, signalling a potential economic slowdown. However, Professor Harvey noted certain factors that made this inversion appear more like a false signal rather than a true indicator of an economic recession. For instance, the high ratio of job openings to unemployment (meaning jobs are available for people who are unemployed), short duration of unemployment (people who are let go are able to find a new job quickly), favourable housing market conditions (the ratio of equity to debt is high), and the resilience of the financial system all suggested that the economy might not experience a downturn.
The Fed’s Role and Self-Fulfilling Prophecy:
Professor Harvey emphasises that the Federal Reserve’s actions play a crucial role in shaping the yield curve’s impact on the economy. If the Fed continues to raise interest rates despite the yield curve inversion, unnecessary stress may be induced, potentially leading to a recession. Moreover, a self-fulfilling prophecy could occur where companies react to the yield curve inversion by cutting back on investments and hiring, thereby slowing down economic growth.
Yield curve inversion, specifically the 10-3 relationship, offers valuable insights into the economy’s future prospects. While historical evidence has shown its association with recessions, it is important to interpret the inversion within the broader economic context. Market participants, investors, and policymakers closely monitor yield curve dynamics to make informed decisions, manage risk, and gauge potential economic downturns. Understanding the significance of the 10-3 yield curve inversion helps in navigating the complexities of the financial landscape and aids in making more informed financial decisions.