We use a range of cookies to give you the best possible browsing experience. By continuing to use this website, you agree to our use of cookies.
You can learn more about our cookie policy here, or by following the link at the bottom of any page on our site.

Free Trading Guides
EUR/USD
Mixed
GBP/USD
Mixed
USD/JPY
Bearish
Gold
Bullish
Oil - US Crude
Bullish
Bitcoin
Bearish
More View more
Real Time News
  • Join @JWagnerFXTrader 's #webinar at 9:30 AM ET/1:30 PM GMT at the US market opening bell. Register here: https://t.co/9pXwJzGj54 https://t.co/fv1BPC7j4n
  • IG Client Sentiment Update: Our data shows the vast majority of traders in Ripple are long at 96.05%, while traders in US 500 are at opposite extremes with 76.29%. See the summary chart below and full details and charts on DailyFX: https://www.dailyfx.com/sentiment https://t.co/o62p1BdjzF
  • LIVE NOW: Join Technical Strategist @MBForex as he hosts his Weekly Strategy Webinar on the setups we're tracking into the open! https://t.co/dFw88WP8eH
  • RT @chigrl: ICYMI overnight >#China seeks $2.4 billion in sanctions against U.S. in Obama-era case: WTO https://t.co/p7O1taMbsO https://t.…
  • Forex Update: As of 12:00, these are your best and worst performers based on the London trading schedule: 🇳🇿NZD: 0.35% 🇦🇺AUD: 0.33% 🇬🇧GBP: 0.26% 🇪🇺EUR: 0.02% 🇨🇭CHF: -0.04% 🇯🇵JPY: -0.13% View the performance of all markets via https://www.dailyfx.com/forex-rates#currencies https://t.co/yNdPOvkwdE
  • Weekly Strategy Webinar starting in 15mins on DailyFX! https://t.co/RgnsklZ2Gl
  • Currency Wars: Tools that are used in a currency war https://www.dailyfx.com/forex/fundamental/article/special_report/2019/10/16/Currency-Wars-What-to-Expect-if-a-Currency-War-Breaks-Out.html?CHID=9&QPID=917713
  • CFTC update - Surprisingly, $GBP net shorts were relatively unchanged, despite the 5% rally. Adds further fuel to an extended rise - Weak demand for safe havens as speculators flip to net short in $JPY - $NZD bearish positions still very extreme https://www.dailyfx.com/forex/technical/article/cot/2019/10/21/GBPUSD-Shorts-Unchanged-Despite-Rally-Japenese-Yen-Flips-to-Short---COT-Report.html?CHID=9&QPID=917713 https://t.co/PxKOjjXjS4
  • RT @JMahony_IG: Useful graphic from @ING_Economics 'Where it could go wrong for UK prime minister Boris Johnson' #Brexit #BrexitVote https…
  • Join @MBForex 's at 8:30 AM ET/12:30 PM GMT for his weekly #scalping #webinar Register here: https://t.co/VAnAfZU02T https://t.co/MDGLWr8s3Z
Why Does the US Yield Curve Inversion Matter?

Why Does the US Yield Curve Inversion Matter?

2019-03-27 12:00:00
Christopher Vecchio, CFA, Sr. Currency Strategist
Share:

US Yield Curve Inversion Talking Points:

  • With US equity markets plunging this week, financial news media has been quick to point out movement in the bond market as the key catalyst.
  • Certain measures of the US Treasury yield curve have started to invert, sparking fears that the US economy is heading towards a recession within the next two years.
  • However, the key yield spread that traders should watch – the 3m10s – has yet to invert, so recession fears should be contained for now.

See the DailyFX Economic Calendar and see what live coverage for key event risk impacting FX markets is scheduled for next week on the DailyFX Webinar Calendar.

US equity markets have been struggling the past few days, with a variety of reasons being offered up: Brexit; the US-China trade war; and the Federal Reserve’s rate hike path, among others. But a new explanation has appeared in recent days, one that has yet to make an appearance in 2018, or really at any point in the past decade: the inversion of the US Treasury yield curve.

Why Do Investors Look at the Yield Curve?

The yield curve, if it’s based on AA-rated corporate bonds, German Bunds, or US Treasuries, is a reflection of the relationship between risk and time for debt at various maturities. A “normal” yield curve is one in which shorter-term debt instruments have a lower yield than longer-term debt instruments. Why? Put simply, it’s more difficult to predict events the further out into the future you go; investors need to be compenstated for this additional risk with higher yields. This relationship produces a positive sloping yield curve.

When looking at a government bond yield curve (like Bunds or Treasuries), various assessments about the state of the economy can be made at any point in time. Are short-end rates rising rapidly? This could mean that the Fed is signaling a rate hike is coming soon. Or, that there are funding concerns for the federal government. Have long-end rates dropped sharply? This could mean that growth expectations are falling. Or, it could mean that sovereign credit risk is receding. Context obviously matters.

Does the US Treasury Yield Curve Inversion Matter?

It’s true that part of the US Treasury yield curve started to invert this week. We’ve seen both 2- and 3-year yields rise above 5-year yields. The “flattening” of the yield curve over the past year, predating this week’s inversion, is rather apparent when comparing the shape of the yield curve today relative to that from last December:

US Treasury Yield Curve (December 6, 2018) (Table 1)

Why Does the US Yield Curve Inversion Matter?

The knee-jerk reaction by many market participants, but mainly financial news media, has been to declare the inversion of the US Treasury yield curve as a harbinger of a forthcoming recession. The stats speak for themselves: yield curve inversions predict recessions (more on this shortly).

While there are certainly good reasons for concern – the US-China trade war, the fading impulse of fiscal stimulus from the Trump tax plan, a housing market that is looking weaker amid higher interes rates – its best to take a step back.

Let’s Ask the Professor

Amid all of the talk about the US Treasury yield curve inverting this week, the Duke University finance professor who is the godfather of yield curve analysis (his 1986 dissertation explored the concept of using the yield curve to forecast recessions) gave an interview to NPR (which can be listened to here). Professor Campbell Harvey made a few key points regarding the yield curve inversion which traders should take to heart:

1) The model Harvey used initially looked at the 3-month, 5-year spread (3m5s), and conventional wisdom points to the 2-year, 10-year (2s10s) spread as the yield curve; all of the concern this week about the 2-year, 5-year (2s5s) and 3-year, 5-year (3s5s) spreads inverting did not interest him, given that they as shorter-maturity instruments didn’t qualify as “short-term” enough in his model;

US Treasury Yield Curves: 3m5s and 2s10 (1975 to 2018) (Chart 1)

Why Does the US Yield Curve Inversion Matter?

2) The yield curve inversions being discussed now are not significant. According to his research, the yield curve needs to invert in the 3m10s for at least one full quarter (or three months) in order to give a true predictive signal (since the 1960s, a full quarter of inversion has predicted every recession correctly);

3) Regardless of the 3m5s and 2s10s curves not inverting this week, Harvey still believes the period of aggressive flattening is significant and it the yield curve is signaling slower economic growth for the US, but not yet a recession.

Read more: US Dollar Unable to Rally Even as Risk Appetite Erodes

--- Written by Christopher Vecchio, CFA, Senior Currency Strategist

To contact Christopher Vecchio, e-mail cvecchio@dailyfx.com

Follow him on Twitter at @CVecchioFX

View our long-term forecasts with the DailyFX Trading Guides

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

DISCLOSURES

News & Analysis at your fingertips.