Produced and photography by Gregory Bobillot. Filmed and edited by Donell Newkirk
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Investors and policymakers have long relied on one bond market indicator to gauge whether or not a US recession is close. That indicator is the US yield curve. Now typically, short term interest rates are lower than long term interest rates because investors demand a bit more compensation to lend on a longer term basis. This is what a typical US yield curve looks like.
Now when this relationship reverses and short-term yields rise higher than long-term yields people often take this as an indication that monetary policy is just too tight and economic slowdown could be coming and that the Fed is going to have to lower interest rates in order to protect the economy. What that leads is for long-term rates to come down below that of short-term rates. And that leads the US yield curve to invert or turn negative, and it looks like this.
Now people pay attention to when the US yield curve inverts because it has turned negative before every US recession of the last 50 years. Now the whole US yield curve wasn't negative over the summer. Only portions of it were. Now one portion of that is the difference between three-month Treasury yields and 10-year Treasury yields, and that turned negative, substantially so, at the end of July and throughout August.
Now as you can see in this chart, this time last year this difference between three month and 10-year yields was as high as 88 basis points. But as the year went on the curve continued to flatten somewhat. And in March, for the first time since the global financial crisis about a decade ago, this portion of the curve turned negative. Now it quickly moved above zero again as the summer continued. It wasn't until July that it turned deeply negative and moved even more so throughout August. At one point in August it was at minus 51 basis points. And that's a sizeable move compared to where we were just this time last year.
Now a few things drove this, for one an escalation of the trade war between the US and China. Now the Federal Reserve did slash interest rates for the first time since the global financial crisis in July. They moved again in September. And they're expected to move once again in October.
Now that has helped steepen the curve. As you can see in the chart, it's now above zero. But it's still flat at just 10 basis points. A few things drove this. There were some positive developments on the trade war front between the US and China. They had reached a preliminary deal, which helped to alleviate a lot of the uncertainties that had been weighing on the global economy. Brexit negotiations were continuing apace, and there's been some progress on that front.
And at the same time, you had the Federal Reserve coming in and announcing that it would buy $60bn worth of Treasury bills. What that has done is to help pull down short-term Treasury yields at the same time that the global growth outlook is brightening a bit, which has helped to lift longer term Treasury yields. Now there's a lot of concerns that this recent steepening that we've seen is going to be short-lived. A lot of the things that drove the steepening, such as the trade war and Brexit, those things are not a done deal just yet. So there's a big, big concern that this recent steepening isn't going to last very long.