After the US yield curve inversion reached its most severe level in almost half a century in mid-2023, it has now almost returned to normal. However, looking back at history, economic recessions have often followed such occurrences. Is the calm before the storm now?
(Background:
Why hasn’t the US economy experienced a recession? Wall Street Journal: These three reasons have avoided a hard landing…)
Table of Contents:
Economic recessions have occurred after the inversion of yield curves in the past half-century.
What is the US bond yield?
What is yield curve inversion?
Economists often say that there is a high probability of an economic recession following the inversion of the US bond yield curve. Currently, according to WGB data, the 2-year bond rate in the US is 4.34%, while the 10-year rate is 4.13%. Compared to the severe inversion that occurred earlier in 2023, with a difference of nearly 100 basis points, the inversion has now almost been resolved (long-term bond yield exceeding short-term bond yield).
However, for the US, which appears to be heading for a soft landing, this may not be a good sign. In the past half-century, every time the yield curve inversion was resolved, it was soon followed by an economic recession. Can the US avoid it this time?
Further reading:
Fed’s dove king predicts two rate cuts in 2024, actions from the Fed will be seen in the third quarter
(Source: WGB US bond yield overview)
Looking at the historical data graph of “Finance M Square” below, it can be seen that the US has experienced a total of five economic recessions from the 1980s to the present, and yield curve inversions have occurred before each of them. Please see the summary below.
1981-1982:
The second oil crisis led to a rise in inflation, and the US central bank’s strong monetary tightening pushed the economy into recession again.
1990-1991:
Tightening of monetary policy, combined with the Gulf War causing supply shocks and pushing up inflation again.
2001:
The dot-com bubble burst, coupled with the impact of the 9/11 attacks.
2008-2009:
The US housing credit collapse and the outbreak of the financial crisis.
2020:
The global lockdown due to the spread of the COVID-19 pandemic.
Except for the COVID-19 pandemic in 2020, the previous four economic recessions all happened after the inversion was resolved. If history repeats itself, investors who expect stable economic growth in the US may need to “fasten their seat belts” because indicators such as the stock market, CPI, and unemployment rate are considered lagging indicators of the economy.
Further reading:
Wall Street Journal: 60% of economists believe that “the interest rate cycle has ended,” and the US will avoid an economic recession.
As the world’s largest economy, the US is generally considered to have a low risk of default on its issued bonds, making them popular among investors. The so-called “US bond yield” simply refers to the return on investment for this type of investment.
Usually, when the US issues bonds, there are “face value” and “coupon interest.” The bond yield is calculated as “coupon interest / face value * 100%.” As the coupon interest does not change but the face value fluctuates with market demand, the bond yield will vary.
For example, if you invest in a US bond with a face value of $1,000 and receive $30 in coupon interest after one year, the annualized investment return is 3%, which is the bond yield.
However, when the demand for bonds decreases, investors can buy them at a lower price, such as $800. In this case, with the coupon interest unchanged, the bond yield becomes 30/800 * 100% = 3.75%.
The yield curve, also known as the yield curve, is a chart composed of the bond yields of different maturity dates. Normally, bonds with longer terms require more time to recover the principal, and they carry more risks (such as inflation and war), so the yield is usually higher.
But as the risk of an expected economic recession increases, investors gradually reduce their holdings of risky assets such as stocks and increase their holdings of long-term bonds (causing an increase in the face value), which leads to a decline in long-term bond yields. This results in a “yield curve inversion,” where short-term bond yields are higher than long-term bond yields.
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