The focus by markets and the media on recession risks that were signaled by the brief inversion of the 10s/2s US yield curve in 2019 failed to recognize the key differences between the 2019 inversion and earlier episodes. In those cycles, when the inverted yield curve proved a reliable recession indicator, the inversion occurred after a period of tightening financial conditions and Fed policy (eg, 2008/09). Furthermore, the inversion persisted for some months, and was matched by inversion of the 30 yrs/2yrs curve, unlike 2019, when it did not, and the Fed eased policy by 75 bp, rather than tightened. So there were more differences than similarities between the 2019 inversion and that of 2007/08, or 1999/2000 (see Chart).
The key point is the message from an inverted 10s/2s curve needs to be confirmed in (a) a tightening of financial conditions, (b) an inversion of longer maturities, and (c) persistent inversion, whereas the US 10s/2s yield curve actually finished 2019 steeper than it started. Also, regime shift to a much lower nominal GDP growth and inflation regime since 2009 and QE may have changed the information content of a flat yield curve. Lower inflation rates mean the term premium protection investors require for holding longer dated fixed coupons is reduced, ceteris paribus. Term premium estimates have been falling since the 1980s as a result. Finally, regulatory pressure to asset/liability match and longevity risk are other factors driving structurally flatter yield curves.
Originally Posted on January 23, 2020 – The Recession That Never Was…
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