Some investors are worried that a recession may be looming in the US – next year, if not sooner. Many investors and analysts are closely watching the yield curves, which have been a reliable leading indicator of recessions for the last 50 years. Data from the Research Division of the Federal Reserve Bank of St. Louis (FRED) indicate that the two-year and 10-year Treasury yield curve declined dramatically between late November and early December 2018. The two-year and 10-year spread reached its tightest level since June 2007 on both December 4 and December 11 at 11 basis points (bps).
Simply put, an inverted yield curve occurs when a short-term Treasury bond has a higher yield than a longer-term bond. The most commonly watched yield curve is between the two-year and 10-year bonds.
Yield curves in general represent the yields on US Treasurys with different maturities. Short-term yields are heavily influenced by the actions of the Federal Reserve Board (Fed), while long-term yields are more heavily influenced by the market’s longer-term view on economic growth. The Treasury yield curve, therefore, is often a proxy for investor sentiment on the direction of the economy.
According to CNBC, a 10-year Treasury bond usually pays a higher interest rate than a two-year Treasury bond to compensate investors for the risks associated with a longer holding period. The difference between these two bonds is called the spread. If the spread is greater than zero, the yield on the 10-year bond is higher than the yield on the two-year bond. Under this circumstance, the spread between these two bonds will create an upward-sloping yield curve. However, when the spread is negative, the two-year bond has a higher yield than the 10-year bond, and the yield curve inverts.
CNBC also explains that banks make more profit by borrowing short term at lower interest rates and charging borrowers higher longer-term interest rates. When the spread is negative, banks will lose money on their loans, turning their business unprofitable and forcing them to cut down on their lending. This will likely trickle down to reduced business investments and hiring as businesses won’t be able to access capital from banks. If such an environment persists, the US economy will slip into a recession. It is important to remember that the statistic that specifically refers to an inversion is the spread between the two-year and 10-year Treasury bonds. The alarm in the markets in December 2018 was caused by the inversion of the two-year and three-year Treasury bonds and the five-year Treasury bond. According to the aforementioned CNBC article, the three-year and five-year Treasury yield curve inverted an average of 26.3 months before the recession in the last three recessions.
The three-year and five-year yield curve inversion may be foretelling that a recession is imminent; however, a yield curve is not a singular factor that could move the economy from growth to recession overnight. Yield curves tend to move slowly, and investors should view the inversion as a process rather than an event. The yield curve has been flattening for a few years, but the economy has kept humming along. Many factors have counteracted the effect of the yield curve on the overall economy, including the tax cuts signed into law by President Trump in December 2017, a strong labor market and robust consumer confidence.
At the same time, markets have gyrated on factors like the US-China trade tensions, rising short-term interest rates, the length of the current business cycle and declining bond buying by the world’s central banks. The Financial Times reported that not a single company in the US had borrowed money through the high-yield corporate bond market in December 2018 at the time of the writing. It would be the first time since November 2008 that no high-yield bonds were issued in the market, further illustrating the uncertainty in the markets.
The yield curve should not be ignored completely, but it’s important to weigh all the risk factors cautiously and find opportunities in the mix. Rising interest rates usually translate to rising cap rates and, thus, declining property prices. In general, higher interest rates also mean that investors will have to make higher interest payments on their debts. It’s reasonable to believe that the yield curve will likely widen through 2019, but remain at low levels. Investors should be vigilant about their loan-to-value (LTV) ratios, income growth projections and whether their income growth will be able to service their debt. This may mean negotiating lease renewals now when the economy is still healthy and refinancing the loans at a lower rate while it is still available.
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