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US yield curve inversion could herald crisis, recession

As a bellwether of asset price fluctuation, the spread of short- and long-term Treasury bonds has attracted much attention from capital markets. On Wednesday, the yield of two-year Treasury bonds and the yield of 10-year Treasury bonds inverted for the first time in more than a decade. That means the yield on the 10-year Treasury bill broke below the two-year rate.

Two-year and 10-year Treasury bond yields are regarded as reliable, strong warnings of economic recession. Not surprisingly, the Dow Jones Industrial Index, S&P 500 and NASDAQ Composite Index closed down 3.05 percent, 2.93 percent and 3.02 percent on Wednesday.

In fact, Treasury bond yields have declined since the beginning of 2019. On January 3, 10-year bond yields fell to 2.56 percent and one-month yields fell to 2.42 percent. While the federal funds rate was only 2.4 percent, the short- and long-term spread narrowed by a large margin. Consequently the Treasury bond yield curve became extremely flat.

On March 22, 2019, the yield of 10-year and three-month Treasury bonds was inverted for the first time since 2007. That day, the Dow Jones, S&P 500 and NASDAQ finished down 1.77 percent, 1.9 percent and 2.5 percent. The result was that shockwaves rippled across global markets.

The shape of the Treasury bond yield curve reflects the trends in short- and long-term spreads. The inversion stems from high short-term interest rates because of the US Federal Reserve's recent interest rate increase, the Fed's balance sheet reduction or other tightened monetary policies.

The Fed raised interest rates four times in 2018, resulting in an overall increase in the yields of short-term US Treasury bonds in 2019 compared with the previous year. In addition, the effective Federal Fund Interest Rate was 2.44 percent on May 1, which was very close to the upper limit of the Fed's interest corridor of 2.5 percent. This indicates that the Fed's short-end interest rate is very high.

The low level of long-term yields of Treasury bonds has also had an effect. Since 2019, the yield of US 10-year Treasury bonds has declined, and long-term Treasury bonds continued to decline from 3.24 percent on November 8, 2018 to an expected level of around 1.5 percent in the near future. The decline in long-term yields stems from the decline in term premiums.

Finally, the Fed's 25 basis points interest rate cut in July is an important measure to prevent the short- and long-term Treasury bonds spreads from inverting, but the effect was limited because the impact of the rate cut was not aggressive enough, compared with cutting 50 basis points.

As a compensation for liquidity risk, the yield in long-term bonds is often higher than that of short-term bonds. Short-term yields exceed long-term bond yields, which means that the market expects the current economic growth rate will be higher than in the future, that is, the economic growth rate will go down or even lead to recession.

According to statistics on the inversion of the maturity spreads of US Treasury bonds since 1970, the longer the inversion, the greater the possibility of economic recession. For example, when the dotcom bubble burst, from February 2000 to January 2001, the spread of interest rates was inversed. From June 2006 to June 2007, the spread of interest rates was inversed, and then the sub-prime crisis occurred in 2008. Upward inflation from the period of 1988 to 1989 also inverted term spreads. During periods of tightened monetary policy, a US Treasury bond inversion is more likely.

Long periods of inverted treasury yields have tended to presage crises in the US. Whether or not there was financial crisis depended on the duration of the inverted Treasury yields, the economic fundamentals, the condition of labor market and inflation. The US economy displays sound fundamentals and a strong labor market, so it is too early to tell whether this inversion is a strong indicator of a coming recession or not.

However, there are other risks hidden in the process of inverted treasury yields, such as the rapid expansion of leveraged loans since the financial crisis. Corporate loans outstanding in the US in 2018 amounted to $1.1 trillion, at a 20 percent year-on-year increase, per the Fed's statistics.

Additionally, most of the bonds issued under low interest rates are poor. If the US economy deteriorates beyond expectations, the spreads on bonds of these highly leveraged borrowers will widen and the balance sheet will be under tremendous pressure. In severe cases, there will be a large number of corporate debt defaults, and the default repayment crisis will cause a chain reaction, aggravating the economic downturn and recession.

On top of that, the US government will find that the rising government leverage limits room for federal fiscal expansion.

The downward or negative yield on US Treasury bonds is conducive to alleviating the growing interest burden on US Treasuries. As the market is concerned over an incoming crisis and recession, hedging assets are being overbought. Long-term bond yields have accordingly been in decline.

Can the deviation be corrected? The US has rowed back its tariff escalation and the Fed may be forced to cut interest rates by 50 basis points once again to ensure that the country's economic fundamentals will not deteriorate further.  

本文刊于《环球时报》英文版,2019年8月19日,“MARKETS,INSIDER'S EYE”栏目



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