The yield curve is inverting. That’s signaled recession since the ’60s. Now what?

Barry Adcock April 22nd, 2019

Can we predict the future by looking at the past? When you’re talking about finance, the answer may well be yes. Every recession we’ve had since the 1960s occurred about a year after an inversion of the Treasury yield curve. And, it looks like that’s starting to happen right now. But it’s not time to circle the wagons just yet.

Here’s a quick primer on the yield curve: It’s a line that indicates yields across maturities, and in very basic terms it means longer-term investments, holding a note or bond across the long haul, are better bets than short-term investments. When it inverts, you’ve got trouble. Short-term rates run high when there’s a tight monetary policy causing an economic slowdown, or investor fears push down long-term rates. Either way, if history is our guide, recession follows about a year later.

The U.S. Treasury yield curve has been flattening for some time and now we’re starting to see the dreaded inversion. It happens when long-term rates drop below short-dated bonds. Looking at the curve right now, the inversion between the one-month and seven-year points on the curve means the one-month yield is higher (2.43% as of April 2, 2019) than the seven-year yield (2.38%).
The key, though, is to pay close attention to what’s happening between the two-year and 10-year spread. The flattening is primarily a tightening of the spread (18bps) between the two-year yield (2.30%) and 10-year yield (2.48%) as of April 2, 2019. This is generally considered by the market as an indicator of inflation expectations.

What does it all mean? If we see inversion in the two-year to 10-year yields, that could be a signal that banks will experience credit issues if a recession follows, which, based on history, it likely will.

What is next for the curve? Will we see more inversion?

Why is the inversion happening? Is it because of rising front-end rates or falling back-end rates? It makes a difference.

The yield curve has been flattening in part because the Fed has been steadily raising the Fed Funds rate since 2015, citing concerns about future inflation as their reasoning. This has pushed short-term yields up.

But, not so fast. The latest signals from the Fed indicate their fears of inflation are subsiding based on the economic data they are reviewing. The bond market hasn’t shared their opinion about inflation, which is why longer-term rates have stayed low.

Also, recent years of quantitative easing efforts that caused global banks to deal in more government bonds have put us in a unique position. We just can’t say for certain that the inversion means an impending recession. In fact, one leading economist, Ryan Sweet of Moody’s Analytics, told MarketWatch in late March that he believes the Fed isn’t going to hike rates further, and that we’re all panicking needlessly about the yield curve inversion.

What should banks do now?

Will it or won’t it cause a recession? Banks have to be prepared either way, and respond based on what they believe about inflation and yields.

If they think inflation is on the horizon and long-term rates are going to rise:

  • Promote longer-term CDs to lock in funding costs.
  • Keep terms short on fixed-rate loans.
  • Make more variable-rate loans that will reprice as rates rise.

If they think curve inversion and a recession may be around the corner:

  • Keep CD rates short (12 months or less) to take advantage of lower rates in the future if the Fed has to lower the Fed Funds rate in response to a recession.
  • Make more fixed-rate loans to lock in yield for longer terms or to use rate floors on variable-rate loans to protect against future rate cuts.

How does the Dashboard help?

Banker’s Dashboard is a powerful tool to help you stay on top of what’s happening out there and inside your own bank. The Dashboard:

  • Provides visibility into the loan portfolio and the mix of fixed- vs. variable-rate loans.
  • Provides a loan pricing tool tied to the market expectation of rates to be sure they are pricing to the most recent movements in the yield curve.
  • Provides a rate shock tool to forecast the impact of rate changes on variable-rate loans.
  • Keeps the Fed Funds futures curve on their dashboard so they can see what market expectations are every day.
  • Provides visibility into the bank’s CD maturities to help them formulate rate strategies and communicate with staff.
  • Provides transparency and accountability for those on the front line opening new CDs each day.
  • Provides a maturity repricing tool to forecast the impact of CD rate changes on maturing CDs.

While many people are taking the yield curve inversion as a harbinger of doom, others are saying history is not going to repeat itself. Either way, the Dashboard provides fast, accurate information about your bank’s fiscal health, giving insights to make sound decisions whatever this yield curve indicates. Want to learn more? Contact us at Banker’s Dashboard.

This content is accurate at the time of publication and may not be updated.