One myth upheld even by many people who has a basically sound outlook on monetary issues is the view that an inverted yield curve (where short term interest rates are higher than long term interest rates) will cause a recession. It is a well known fact that the yield curve tends to invert just before recession, so therefore many people have concluded that the inversion of the yield curve is a causal factor behind the recession.
The implication of this is that the sharp increase in long-term bond yields (up more than 50 basis points) the last 2Â½ months is actually bullish for the economy!But why would it cause a recession? Well, because supposedly banks raise funds whose cost is determined by short-term interest rates while the interest rates of their lending is determined by long-term yields. And so, if the yield curve inverts, banks will find it unprofitable to lend, ending credit expansion.
In reality, this picture is for the most part misleading. Most lending to households are in mortgage debt, which is usually financed by the issuing of bonds with the same maturity as the mortgage (In adjustable rate mortgages, it is in short-term debt, but then the interest income for the bank will rise too if short term rates rise) Moreover, banks do not always raise deposit rates by as much as the central bank rate and often they lend with adjustable rates. All of which make the causal recessionary link very weak, at best. And whatever link there is, is likely to be more than overwhelmed by the negative effects that rising long-term interest rates have on mortgage lending, stock prices and other parts of the economy. This makes a rise in long term rates bearish for the economy even if it makes the yield curve slope more positive.
So, if it is not a causal factor, why are recessions usually preceded by an inverted yield curve? This is simply because long term yields are fundamentally determined by future short term interest rates. Otherwise, people could make large arbitrage profits by borrowing with short term interest rates and lending in long term interest rates (or vice versa). And as short term interest rates are at their highest during the cyclical peak, they will be above the cyclical average during those peaks, which in turn means that short term interest rates will be above long term interest rates at those points. However, this assumes that the markets will successfully predict the cyclical peak in interest rates. If they think they have peaked, but inflation and the economy for some reason unexpectedly accelerates, then a recession will not follow an inverted yield curve.
The case of Australia is particularly interesting in this context. The yield curve has been inverted almost all of the time since late 2004. Yet as I reported yesterday, Australia’s economy has not only not slipped into a recession, but is enjoying very strong growth. Of course, this is again mainly a result of the sharp increase in demand for Australian commodities from China. But this is not just a case of a third factor (the commodity boom) preventing the outbreak of a recession. The inverted yield curve is in fact combined with double digit monetary growth, illustrating that an inverted yield curve need not be associated with tight monetary conditions.
In short: an inverted yield curve tends to be associated with recessions because they reflect market expectations of an imminent peak and reversal of central bank interest rate increases. But they are not a causal factor behind recessions (at least not to the extent they reflect lower long term yields) and so rising long term yields are not bullish for the economy.