U.K. Experience Suggests an Inverted Yield Curve Isn’t All Gloom and Doom

In the U.S., a drop in long-term yields below short-term rates typically portends a recession, but that relationship may be breaking down

By Anna Isaac of The WSJ. Excerpts:

"A widely watched U.S. recession signal has been blinking red for months now. Yet the performance of that gauge, the yield curve, in Britain suggests it is less worrisome than the American experience indicates.

This signal is a bond market phenomenon called an inverted yield curve, which means long-term government bond yields are below short-term interest rates. Since the 1970s, it has appeared before every recession. But in Britain, the yield curve has inverted without a recession, for reasons that might be at work in the U.S. bond market today. Indeed, it might explain why other data, such as the stock market, aren’t sending similarly downbeat signals.

Short-term rates are mostly under the control of the central bank, while long-term bond yields are driven by investors. Normally, long term rates tend to be higher than short ones, to compensate investors for tying up their money for more time, with all the additional uncertainty that involves in terms of inflation, economic growth and monetary policy.

But when investors believe there’s a recession coming, that relationship can flip. They flee to the safety of bonds over riskier investments such as stocks. When demand pushes the price of bonds up, their yields go down. Investors, in these circumstances, also expect the central bank to cut interest rates to try to counteract a weak economy. Such a step would restore the normal relationship. Every time the U.S. 10-year Treasury yield has sustained a drop below the three-month T-bill since the 1970s, a recession has followed. There have been no false positives."

"Investors typically expect government bonds to rise in value during a downturn as yields decline. With yields in Europe already in record-low or negative territory even before a recession hits, investors may no longer believe European bonds can act as a hedge against falling equity prices, said Scott Theil, managing director and deputy chief for fixed-income investment at BlackRock. They may be buying U.S. Treasurys for their better returns, helping nudge their yields below short-term rates.

That’s not all. The compensation investors receive for tying up their money in long- instead short-term bonds, is called the term premium. If investors see little risk of inflation climbing meaningfully in the future, they may accept a low or even negative term premium. That translates into lower bond yields and more frequent inversions of the yield curve."

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