The current inversion of the yield curve in the United States and Europe has heightened investors’ concerns about a coming global recession.
But what is the principle of this “technical” mechanism, and why is it considered to be the harbinger of a contraction in economic activity?
Yield curve
The yield curve refers to the graphical representation at a time t of an instrument on its different available maturities.
When we speak of the American yield curve, we therefore refer to the yield curve of American government bonds, generally from 3 months to 30 years (T-Bills at less than one year, T-Notes from 2 to 10 years and T-Bonds beyond). When it comes to that of German rates, reference is made to that of Bund yields, on equivalent maturities.
Usual shape of a yield curve
Generally, a yield curve has an upward slope. Investors consider it more risky to lend in the medium or long term than in the short term, they demand higher returns as the maturity increases.
In a classic configuration, the curve is relatively steep in its first part (reflecting significant differences between two maturities) then tends to gradually flatten. In fact, there are rarely significant differences in risk perception between two very long maturities.
Curve inversion
We speak of an inversion of the curve when short-term yields become more important than medium-long-term yields. From a graphical point of view, the curve then displays a downward slope in its first part. Hence this qualification of inverted curve.
To measure the magnitude of the reversal, specialists use the concept of spread, that is to say the difference in rates. If the 10-year rate is 1.5% and the 2-year rate 1%, the 10-2-year spread is +0.5%. In other words, the 10-year rate is 0.5 points above the 2-year rate.
Conversely, if the 2-year rate is higher than the 10-year rate, the spread becomes negative.
This Thursday, December 1, 2022, for example, the German yield curve briefly reached its deepest inversion since 1992. The spread between 2- and 10-year government bond yields fell to -31 bps to narrow by the following -0.21 bp this Friday, December 2.
Meaning of the inversion
An inverted curve can have several causes. When yields on longer-term bonds are lower than those on short-term bonds, this may first suggest that investors expect a rise in central bank interest rates in the near future before a decline. thereafter to cope with the slowdown in growth. The rise in short rates then has repercussions on the markets, while long rates anticipate a fall in the longer term.
But it can also reflect a more general concern of the markets about a short-term recession, independently of monetary policy.
In a market environment with high risk aversion, long-term bonds – reputed to be safer than equities – are in greater demand: their price rises and their yield falls. And for short-dated ones, considered riskier, investors are actually demanding higher returns.
We guessed it: the current situation is mainly due to the first case and the actions of the Fed, although the effects of bond demand linked to macroeconomic fears (energy crisis, war in Ukraine, etc.) also weigh in the balance.
And now ?
Experience has shown that past inversions have often preceded an economic recession, but yield curve inversion is not an exact science. The long period of low rates in the United States that followed the 2008 crisis made this interpretation less relevant in particular: since rates remained stuck close to zero, the spread remained in fact still quite narrow.
The movements on European government bonds are also less reliable than those observed on the American markets, considers Christoph Rieger, head of studies on rates and credit at Commerzbank. ” I think the European Central Bank (ECB) will continue to raise rates more than the market and many people are predicting. he told Reuters on November 25.
The prospect of a recession on the Old Continent, however, remains a very plausible scenario. This is in particular that of the European Commission, which forecasts a decline in GDP for the euro zone in the last quarter of 2022 and in the first quarter of 2023 (“technical” recession, drop in GDP for two consecutive quarters) to reach +0.3% over the together next year.
The outlook in the United States, on the other hand, is more positive: the latest employment and inflation figures give hope for the resilience of the American economy.
On a global scale, the OECD forecasts are also a little more optimistic: world GDP growth should slow to 2.2% in 2023 against 3.1% this year, the organization predicted on November 22.