Short rates have gone up in the US. Longer rates less so. The yield curve has flattened; is flattening; and conventional wisdom has it that this will continue. In due course, short rates will yield more than long rates. Think of, for example, two-year bonds at 3% and 10-year bonds at 2.875%. No problems with the maths, but does it mean anything?
The second part of that conventional wisdom is that as the yield curve inverts it is the amber light for a forthcoming slowdown. However, unlike the amber traffic lights which are typically set at five seconds, there is no predetermined time after which there has to be a recession, indeed if it all. It could be a year (as we saw in 1990) or many years (as we saw in the late 1990s). That is the stuff for bond fund managers’ debate – but there is a determinism here. What if the patterns over the past hundred years are wrong? What if it is different this time?
Enter analysis from BNP Paribas. Its research shows that up until the 1930s the yield curve was almost always inverted (i.e. it’s not different this time, it’s just that we haven’t seen this for a long time!) Perpetual Gilts traded at a premium to short dated “call” money. It is worth thinking of it like this: Those people who had money didn’t want the hassle of chasing higher yields from the lightly regulated banking system. Stay safe with Gilts and let those who really needed money squabble for it at higher yields. No doubt a simplistic view of the materially less regulated world of late 19th Century bond markets, but there are parallels with today. Regulation demands that a whole chunk of pension fund money is locked away for the long term in safe assets almost irrespective of the cost of “call” money, which is creating ( as we have seen many times and continue to see in long Gilts) an inverted yield curve.
So why debate this now? The Fed is spending a lot of time worrying about what an inverted yield curve might mean for expectations as well as economic reality. As the graph below shows: the pre-1930 world was far choppier in terms of recession and expansion.
US Yield Curve Versus RecessionsSource: Macrobond, BNP Paribas
Todays’ sophisticated world of central banking and generic 2% inflation targeting provides stability; but as Quantitative Easing stops and the unwind drips the stock of bonds back to the market we are in unchartered territory. It might just be a little too easy to assume an inverted yield curve means upcoming recession.