This Time it is Different, Again

Updated: May 17

A lot of attention in the media recently has been devoted to the inversion of the yield curve in the US in late March. There is one main reason for this: yield curve inversion has in the past reliably signalled an impending recession. Should we be worried?

"The problem comes when low short-term interest rates result in an overheating economy"

A yield curve is a graph mapping an interest rate, say 2.6 per cent, on the vertical axis against interest rate maturity on the horizontal axis, say 1 year or 5 years. Curves can be for different markets such as government or corporate bonds. In the case of many developed countries, government securities – bills or bonds – are considered to be risk- free, in the sense that they are free of default risk.

Since risk-free rates are the basis of pretty much everything in finance, the most important yield curve is the one that represents the curve of government or safe-haven bonds. At the left-hand end of the scale sit 1-year Treasury bills or gilts that represent short term interest rates. 30-, 50- or perhaps even 100-year bonds that represent long-term interest rates are to the right.

Over time, interest rates or yields of different maturities will be moving both in absolute terms as well as in relation to each other, depending on what is going on in the underlying economy. When one hears talk of yield curve inversion, as has been the case of late, this means that the short-term interest rate has become higher than the long- term rate.

The short-term interest rate is essentially determined by the central bank and is used by commercial banks to set deposit and lending rates. The long-term interest rate is determined by the market and represents the risk free-returns that savers willing to commit to for the long-term can enjoy.

Most of the time, short-term interest rates are lower than long-term interest rates, in other words, the yield curve is steep. This is because savers should be rewarded and investors incentivised by offering them higher returns on investment than the rate at which they can borrow.

The problem comes when low short-term interest rates result in an overheating economy. Central banks will then increase short term interest rates. Eventually, short-term interest rates rise above long-term interest rates, either because of the former rising or because of the latter falling. The flattening of yield around the world in recent weeks has been essentially due to the latter.

It is hard to attribute the fall in long-term interest rates recently to anything other than weakening global economic growth expectations, particularly since this is supported by the data. However, there are some respected economists who suggest that yield curve flattening or inversion should not nowadays be interpreted as it was in the past. In other words, it does not presage a recession and is thus is not something to worry about. Quantitative easing (QE) over the last ten years, they say, has so distorted interest rates that the yield curve has lost its predictive power.

QE has indeed distorted interest rates – that is what it is designed to do – but not as the naysayers suggest. The end of QE programs to varying degrees across developed world jurisdictions in recent years has represented a de facto tightening of monetary policy.

However, this tightening does not show up as increases in short-term interest rates – QE is required when short term interest rates hit zero and cannot go any lower. In other words, it is possible that monetary policy has been tightened much more than people think by looking at short term interest rates alone, and thus the recent fears about weakening economic growth could well be warranted.

My view is that the argument of those disputing the predictive power of the yield curve has a distinctly “this time is different” feel to it. As the great investor Sir John Templeton once pointed out, those four words are among the most dangerous in the English language.

Published in What Investment

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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