The inverted yield curve of long and short-term US treasury bonds has raised concerns about a US economic recession, but experts said it would be too early to predict a recession given the low inflation and structural problems which cause low long-term interest rates.
Concerns over the US recession heightened last week as the yield on 10-year US treasury bonds fell temporarily below the rate of 2-year bonds and the yield gap between 10-year notes and three-month bills having been inverted for nearly three months since May 23.
The reversal of long and short-term yields on bonds is customarily considered to be a leading indicator of recession.
According to a report published last Friday by the Korea Center for International Finance, when the inverted yield curve has continued for months, since the 1960s, there has been a recession.
In particular, unlike last year when the issue was first raised, the current inverted yield curve has continued for months amid the economic slowdown in major economies due to the intensifying US-China trade dispute.
The inverted yield hurts the economy by reducing the credit supply of financial institutions. Ten years of US government bonds are the benchmark for mortgage rates, and two years for deposit rates. In this regard, the fall of long-term bond yield leads to a weaker interest margin or loss of financial institutions, dampening the supply of credit.
But it is too early to predict a recession.
Given the difference behind the reversal of long and short-term interest rates in the past and current conditions, it is not necessarily a leading indicator of an economic recession, the KCIF said.
Long-term interest rates reveal the bond market’s prospects for future short-term rate flows and inflation, while short-term rates reflect short-term monetary policy stance.
Past recessions came as short-term interest rates rose sharply due to monetary policy tightening. Long-term interest rates fell below short-term rates, as the Fed raised its policy rate in response to rising inflation or asset prices, raising concerns of an economic slowdown.
But now, the Fed has already shifted to monetary easing, so short-term interest rates cannot rise significantly.
The overall inflation and interest rates are also significantly lower than in the past, and there are structural factors that bring about low long-term interest rates.
“It is difficult to interpret that a decline in the long-term interest rate reflects the risks of a future economic recession as quantitative easing by central banks in major economies and aging populations are serving as the backdrop for lowering the long-term interest rate after the global financial crisis,” KCIF said.
In its push for quantitative easing, the US Fed purchased treasuries and now holds US$2 trillion worth of treasuries. Besides, rising demand for the long-term bond by pension funds contributes to a decline in the long-term bond yields.
Janet Yellen, a former Federal Reserve chief, also noted that there are various reasons for low long-term interest rates, adding that the inverted yield curve may not be a sign of an economic recession.
Lee Sang-jae, an economist at Eugene Investment & Securities, also said that the US inverted yield curve reflected the bond market’s excessive concerns about the US economy.
He said: “The market is being overly anxious given the real GDP growth and a rise in retail sales.” US GDP grew 2.1% on-quarter in the second quarter and 2.3% from a year earlier and retail sales also rose 0.7% in July, a higher-than-expected month-to-month growth.
According to KCIF, there are institutional views that downplay a possible US recession. Considering the relatively stable US economic conditions such as consumption, Evercore ISI said the possibility of a recession would be limited.
Capital Economics also said that the reversal of bond yields had little implications for a possible US recession, predicting that the US economy could slow down rather than fall into a recession.
KCIF said the limited room for the Fed to handle potential risks could be a destabilizing factor amid risks such as the US-China trade dispute and global economic downturn.
In other words, the average rate cut in the Fed’s rate-cutting cycle was 5.3% in the past, while the Fed’s current room for additional rate cuts is only 2%.
It said: “We should pay attention to the possibility that the reversal of long and short-term bond yield could serve as a self-fulfilling prophecy that could cause the US economic recession as uncertainties and anxiety are rising due to the prolonged US-China trade dispute, worsening manufacturing conditions in major economies, and inverted yield curve in major economies such as Britain, Canada, Switzerland and Hong Kong.”
“We are also paying attention to some signs that the US economy could turn into a recession,” said Lee of Eugene. “The profit margin of US firms on the US GDP account since 2014 has been significantly downgraded.”
For example, in the first quarter of this year, US corporate profits were revised down to a 2.0% year-on-year loss from a gain of 2.3%, while non-financial firms’ profit margins were lowered to 10.7% from 12.9%.
Considering that non-financial companies’ profitability preemptively shows employment two quarters later, he said: “The vicious circle of employment and consumption may happen to lead to the recession.”
But, he added that it remains to be seen whether it will become a reality. He cited a report by Bank of America Merrill Lynch saying that it is both reassuring and scaring.
He said, according to the report, the reversal of the US long and short-term bond yields have happened five times since 1978: August 1978; September 1980; January 1989; February 2000; December 2005. After the reversal, the US economy reached its peak an average of 15.6 months after, and the S&P 500 index reached its peak an average of 12 months later. The highest increase in the index was 25.4%, and the lowest increase was 11.8%.