Don’t panic: The inverted yield curve doesn’t necessarily signal recession

Do bond investors know something others don’t?
Do bond investors know something others don’t?
Image: Reuters/Eduardo Munoz
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There was a time bonds were considered the boring, predictable asset—all the action was in stocks—but this week was an exciting one for fixed income. The US yield curve inverted. This is when short-term rates are bigger than rates on long-term bonds. It is unusual because long-term bonds are normally considered riskier and pay more yield. It set off alarm bells because, in the US since the 1960s, an inverted curve is often followed by a recession within three years (paywall).

But there are reasons to not worry. Other economic data has been positive, and no one has a good idea why an inverted curve tends to predate a recession. It could be because long-term bonds reveal investors’ expectations about future growth and lower rates mean more pessimism. But that assumes bond investors know something investors in other markets don’t. Or it could just be that in a more global world, the yield curve tells you less about local economic conditions than it used to.

The other cause for concern is how low rates have been. The US 30-year bond is offering less than 2% for the first time ever. Meanwhile in Europe, the entire yield curve in Germany and Switzerland is negative. It seems to defy all economic logic. The foundation of finance is built on the assumption that a dollar today is worth more than a dollar tomorrow.

But there are reasons investors might put off spending, even if it’s for a price. It could be investors fear a recession and want to store their money in the safest asset available. Or investors may be financing future spending, when they know they’ll need money, as in the case of people saving for retirement. An aging population and lower inflation are why many expect interest rates to remain low for the foreseeable future.

As boring as the bond market has been, it can be unpredictable. If the risk outlook changes, rates will increase quickly, and an economy that’s become accustomed to low rates may be in for trouble.

This essay was originally published in the weekend edition of the Quartz Daily Brief newsletter. Sign up for it here.