In December 2005, the US yield curve inverted for the first time since February 2000, which has historically been a predictor of economic recession in the US, according to research from Fidelity International.
An inversion of the yield curve has occurred before every recession in the US since 1950 – with only one exception, and the country may be due for another one, says Paul Lavelle, portfolio manager at Fidelity.
“By its very definition, a recession commonly follows a period of strong or improving economic growth,” begins Lavelle. “In an attempt to stem any associated inflationary pressure, central banks often tighten interest rates during this period. The administration of monetary policy is one reason an inverted yield curve is so frequently associated with a looming recession.
Lavelle said that inversions of bond yield curves happen when the yield on the long-dated bond falls below that of the shorter dated issues — an occurrence, he says is rare and undermines the principle that investors are rewarded for increased risks. But, “in the case of an inverted yield curve, an investor receives a lower return for taking 10-year risk than he or she would be for taking 2-yr risk,”
He adds that the hiking US trade deficit also contributes to the yield inversion.
“The consumption of foreign goods in the US dramatically outweighs the demand for US goods and services abroad,” Lavelle said. “The result is that countries with large surpluses to the US (in particular, China and Japan) have significant dollar reserves which are ultimately reinvested in the US treasury market.”
“So, do I think a recession in the US is looming?” asks Mr Lavelle? “That is almost impossible to forecast. However, if we consider that long term bond yields have also historically been a good indicator of nominal GDP, a 30 year yield of 4.7% is hardly indicative of looming recession.