Recession alarm bells being rung by U.S. bond market

Matthew Meyer, Staff Reporter

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One of the United States’ most accurate economic predictors just signaled an oncoming recession.

On  Friday, March 22, the United States Treasury long-term to short-term bond spread plunged into the negative, depicting an “inverted yield curve.” According to the Federal Reserve Bank of Cleveland, the last time this occurred was in 2006, prior to the “great recession.” Understandably, many investors are growing anxious awaiting the outcome of this situation. Consequently, the Dow Jones Industrial Average fell 490 points (1.8 percent) on Friday alone, and the S&P 500 index fell 1.9 percent.

What exactly is an inverted yield curve, what causes it and does this mean that we are heading into a recession? First, an inverted yield curve occurs when a long-term U.S. Treasury bond has a lower interest rate than a short-term bond. In the current case, the 10-year Treasury bond’s interest rate has fallen below the three-year bond rate.

Last December, investors saw a similar situation when the five-year bond fell below the three-year bond. However, according to the Wall Street Journal, the 10-year to three-year spread is considered to be a far more accurate economic indicator than the five-year to three-year spread.

According to Bloomberg, an inverted yield curve typically occurs as investors become less confident in the well-being of the stock and bond markets. Thus, it is viewed as more risky to invest in short-term bonds, pushing interest rates higher.

Ultimately, the short-term to long-term inversion occurs because investors are less optimistic about the economy in the short run, than they are in the long run, leading the Federal Reserve to set higher interest rates on short-term bonds than long-term bonds.

Although some view the decline in confidence as a natural part of the economic cycle following two years of rapid economic growth, according to ABC News, the German manufacturing market may also be culpable. A few weeks prior to the U.S. Treasury yield inversion, Germany began experiencing the same scenario, following the decline of its manufacturing and automotive industries.

Is the United States’ economic future as grave as some have claimed?

It is too soon to tell. According to the Federal Reserve Bank of San Francisco, every U.S. recession in the past 60 years was preceded by an inverted yield curve similar to the current one.

Despite the trend, there have been false alarms numerous times over that 60-year span. According to a study from Duke University professor Campbell Harvey, the long-term to short-term yield curve should be inverted on average over a fiscal quarter to provide a solid signal, not just for a few days.

Similarly, when asked about the growing concern surrounding the bond market, John Carroll economics professor and global economics specialist Sokchea Lim said, “We should not be too concerned about the Friday event (because) this might be just a one-off episode that was in response to the bad news in the stock market.”

On the other hand, many economists and market experts have been predicting a recession for the past few months. The stock market boom and extraordinarily low unemployment levels that the U.S. has been experiencing for the past two years have been reasonably viewed as unsustainable. Unsurprisingly, multiple signs of recession have begun popping up, and the inverted yield curve is just the latest.

According to Forbes, we are now five years overdue for a recession, as there is typically at least one minor recession every decade. Should this most recent prediction come to fruition, it should not come as a surprise.

Editor’s Note: Information from Forbes Magazine, ABC News and the Federal Reserve Bank of Cleveland was used in this report.