Economic speculation can often feel like a self-fulfilling prophecy. When confidence in the economic future is high, the markets and the broader economy hum along. But when investors, banks and business get nervous, money stops flowing and the whole system grinds to a halt. That’s called a recession.
The United States economy has been riding the longest bull market in history, posting record stock marketgains and historically low unemployment figures. But the fact is, recessions happen and it’s been nearly 10 years since the last one officially ended. While we’re not technically “due” for another market correction, it’s starting to feel that way for some investors. GM recently announced big layoffs and the trade war with China shows no sign of ending soon.
But the clearest indicator that a recession might be just around the corner is a wonky graph called the treasury bond yield curve. As we’ll explain, this single indicator may be the king of all self-fulfilling prophecies, successfully predicting the last seven U.S. recessions and only getting it wrong once.
So what exactly is the treasury bond yield curve? The U.S. federal government sells treasury bonds to investors as a way to borrow money. Treasury bonds are considered the safest investment in the world, because they’re backed by the U.S. government, but they also carry relatively low interest rates. In general, the demand for treasury bonds goes down when the economy is doing well and goes up when the economy is sluggish. That’s because investors are willing to take risks on higher-yield investments when the economic future looks bright and come back to bonds when they need a low-risk safe haven.
Treasury bonds come in a variety of “flavors” or different maturity dates. You can buy short-term T-bills that mature in three or six months, or long-term bonds that won’t fully mature for 10 or even 30 years. Normally, the short-term bonds will have lower yields or interest rates than the longer-term bonds, because a longer investment carries more risk that inflation will eat up your gains over time. So if you plot the yield of treasury bonds on a graph, it will normally curve or slope upward, with progressively higher yields for bonds with two-year, five-year, 10-year and 30-year terms.
But in economics, things aren’t always normal. Every so often, that yield curve flips upside down, with short-term bonds posting higher yields than long-term bonds. And historically, when that happens, a recession is imminent. The yield curve flipped in 2005/2006 as well as in 2000, 1988 and 1978, prefiguring the recessions that followed in the next year or two. The only time the yield curve inverted without preceding a recession was 1998.
So why exactly does the yield curve turn on its head? This gets to the self-fulfilling prophecy part. Bond prices and yields fluctuate according to investor demand. When more investors and companies want to buy long-term bonds, the price goes up and the yield goes down. As we mentioned, when economic prospects look good, fewer investors want to bury their money in a relatively low-yield, long-term bond. But if the future looks shaky, as it does for some investors right now, they start to flock toward these low-risk bonds, driving prices up and yields down even further.
On the other end of the graph, short-term bond yields have been pushed higher by the Fed, which has been slowly raising short-term interest rates in an effort to rein in an overheated economy. Then, as demand for those short-term bonds slows, it pushes their prices down and their yields even higher. The result is a “flattened” yield curve — which is where we are now — that may or may not flip entirely. Right now, the interest rate on five-year Treasury bonds is below the rate on three-year bonds, but rates on even longer-term bonds are still higher.
So why does the specter of an inverted yield curve have recession watchers so worried? Because it’s a sign of lagging investor confidence that can have real effects on the flow of money into the economy.
Wes Moss is the chief investment strategist at Capital Investment Advisors and host of the weekly radio show “Money Matters.” He says that one of the reasons why the inverted yield curve messes with the economy has to do with banks. The way banks make money is by borrowing low and loaning high. When short-term rates are low, they can borrow cheaply by selling a one-year CD at 1 percent and then turn around and loan out that same money at 5 percent on a 30-year mortgage.
“When the yield curve is inverted, it means that short-term money is more expensive than long-term money,” says Moss. “If I’m a bank and suddenly I have to pay 3 percent for CDs and can only loan money out at 2 percent, then I’m not going to want to make those loans. The result is that everything slows down.”
When capital is tight, businesses shelve new projects, freeze hiring or even lay off employees to cut costs. When workers are nervous that they’re going to lose their jobs, they’re less likely to buy a car or build that new dream house. Slowly but surely the economy loses steam, unemployment grows and we’re back in a recession.
Moss isn’t convinced that the yield curve is indeed going to fully invert, although he admits that it’s flattening fast. And even if it does, it doesn’t mean that a recession is arriving tomorrow. “On average, it takes a year and a half from the time the yield curve inverts until the start of a recession,” Moss says.
Of course, if investors think that the economy might fall into a recession and start moving their money into other places, this could fuel the self-fulfilling prophecy even faster.
This article was written by Dave Roos. It is being reproduced and made available with the permission of How Stuff Works. This information is provided to you as a resource for informational purposes only and should not be viewed as investment advice or recommendations. This information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax, or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.