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An explainer on inverted yield curves and is it a good predictor of recession

TORONTO — For the first time since before the Great Recession, the yield curve on two- and 10-year U.S. government bonds has inverted, a possible warning that another recession is on the way.

On Wednesday, the yield on the 10-year Treasury briefly fell below the two-year yield. By late afternoon, the rate was 1.58 per cent 10-year yield and 1.56 per cent two-year yield. However, the spread remains very narrow, a rare occurrence as investors usually demand more interest for tying up their money over a longer term.

This latest inversion is the result of a steep slide in long-term yields as worries mount that President Donald Trump’s trade war may derail the economy. Broader measures of the U.S. economy, meanwhile, are not pointing to an imminent downturn. The job market, consumer spending and consumer confidence all remain solid to strong.

The Canadian Press asked National Bank of Canada Chief Economist Stefane Marion and Candice Bangsund, portfolio manager for Fiera Capital, some questions about this phenomenon that prompted a sharp decline Wednesday in North American stock markets.

What is a yield curve inversion?

Marion: It’s when the payout on a 10-year treasury drops below a short-term bond, either a three-month or two-year rate. Long-term bonds typically yield more than shorter ones to reward holders for waiting longer to get paid, but an inversion reverses that.

Why does it happen?

Marion: People are expecting there’s going to be slower growth ahead. Historically, it occurs when markets believe that monetary policy has been tightened too much and that central banks will need to lower interest rates. What that means is the markets believe that we’re near the end of the economic cycle and therefore expectations of rate cuts are being built in the curve.

Bangsund: Investors are piling into 10-year bonds because they’re nervous about the economy. The market is extremely nervous, extremely negative on the outlook for growth and has piled into fixed income as a result.

What does it signal?

Marion: All recessions have been led by yield-curve inversions and since 1957, there have only been two false signals when the yield curve inverted but a recession did not follow: 1966 and 1998. This is why the markets fear the signal of the yield curve because it’s got a pretty good batting average in terms of forecasting recessions.

Bangsund: The economy is nowhere near recessionary territory. Retail data to be released Thursday will likely show that consumers are still spending. Businesses are still spending and lending conditions are accommodative. We don’t see the red flags or the recession signals despite the fact that the curve has inverted. The curve has inverted because there’s just a general pessimism out there.

What’s unusual this time?

Marion: Monetary policy is not seen as being restrictive and central banks are expected to lower interest rates even more. Really, this trade war uncertainty is starting to bite and the stress is not coming from the central banks so the inversion of the yield curve stems from tariff wars and uncertainty.

Bangsund: The market doesn’t believe that central banks are going to be successful helping the economy and the trade backdrop adds a high level of uncertainty because its hard to predict and gauge. What’s different is we’re nowhere near what would constitute a tight monetary policy environment. If anything, real rates are negative and lending conditions are very accommodative.

Is this the first inversion in 2019?

Marion: No. Three-month bonds inverted with 10-year treasuries in March. What’s unique is that the shorter-term bond inverted before the two-year bond. When the three-month bonds inverted, some economists warned that it may not be an accurate forecasting tool.

Is the two-year bond inversion a better signal?

Marion: Not necessarily. We’re not seeing a collapse of consumer confidence or business confidence as we would normally see during an inversion of the yield curve. This is the reason why I’m hoping that if the trade war does not escalate we might be fortunate that the cycle will be prolonged and it will be the third false signal after 1966 and 1998.

How soon could a recession be in the offing?

Marion: On average, a recession hits within 10 months of a yield inversion.If you believe this is a real signal, well on average you have 10 months before the next recession, so since the inversion started last March, you could say that would mean a recession early in 2020.

Are Canadian bonds inverted?

Marion: In fact, Canadian bonds inverted before U.S. bonds but aren’t seen as solid a signal. Canadian 10-year bonds had a yield of 1.16 per cent, compared with 1.36 per cent for two-year bonds.

Ross Marowits, The Canadian Press

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