The “Yield Curve” is nothing more than a line between the dots on a graph of interest rates. At the start of the graph (on the left) is very short term interest rates and at the end of the graph (on the right side) is longer term interest rates.
When long term interest rates are lower than short term rates it means business is expected to DECREASE over time. When the graph trends down, it is called an “inverted yield curve”
To be clear, the technical definition of an inverted yield curve is a 10 year interest rate that is lower than the the 2 year interest rate (aka. 2s vs 10s).
How Often Does An Inverted Yield Curve Predict a Recession?
If business decreases for more than 3 months in a row, economists call it a recession and that means :
- businesses stop investing and growing because sales are declining
- jobs are lost
- elections typically see the incumbents replaced
Recessions happen for many reasons and are very hard to accurately predict but there is one metric that precedes most recessions, an inverted yield curve. Since 1956 all previous recessions have hit about 15 months after the yield curve inversions.
A very big problem with recessions is that, like a run on a bank, they occur whenever people THINK they will occur. They are a self fulfilling prophecy. That is not to say that a recession is absolutely guaranteed but in today’s data driven world, the yield curve is taken very seriously. That is why stock markets ALWAYS tumble when the yield curve inverts:
- investors get scared and sell their some of their stocks
- driving the price of those stocks down
- causing companies and citizens to THINK something is wrong and start holding off on discretionary purchases
- which further causes demand / sales to drop
- which causes a recessionary loop
How Likely Is a Recession Likely in 2020?
Merrill Lynch answers this question nicely when last week they said:
“S&P 500 (is) on borrowed time if the 2s10s yield curve inverts,” SOURCE
and that just happened today.
What Other Factors Are There To Consider When Predicting A Recession?
The US economy is has been expanding for the last 11 years an the average expansion is about a decade, meaning that we are overdue for a recession.
Anything that causes notable uncertainty can cause companies to stop expanding and that will cause a recession. In today’s world:
- the US China trade war has caused a considerable amount of uncertainty
- Brexit has been a serious generator of uncertainty
- wreckless borrowing by the US Government under President Trump causes businesses and investors to think that the good times have to be paid for soon
- so many companies (Microsoft, Apple, Amazon…) crossing the $1 Trillion dollar market cap has caused investors to be uncertain if growth can continue
- social and political upheaval like that in Hong Kong, one of the worlds most important trading hubs, causes global uncertainty
- terrorist attacks, even small ones that make the news and enter our collective consciousness, causes business uncertainty