Timothy Spurlin: Observe the inverted curve

Sunday, September 8, 2019 - 4:24pm

College students ought to be interested in the recent inversion of the yield curve, as its ramifications could potentially pose a significant threat to our post-graduation plans.

For those who don’t know what the yield curve is, it is a graph that plots different bonds by their contract length and their respective yields, or how much one gets back for investment. Typically,10-year bonds have higher yields because that means people are lending out their money for a longer period of time and thus should expect a greater return on their investment. However, for the first time since 2006, the yield curve recently “inverted,” meaning that short term yields increased above long term ones.

Why is this such a big deal? Bonds are generally a much better measure of the economy’s health than other markers, such as stocks, for a couple reasons. First and foremost, the variability of the stock market is pretty much unpredictable. When it is up or down, people will offer their thoughts on what has influenced it as a whole, but typically the day-to-day just sometimes changes. Bonds are like stocks but are generally considered safer due to their complexity and guaranteed returns. As business journalist Heidi Moore eloquently explained in a tweet thread: “The stock market is a way that people tell short stories about a company … Bonds also tell a story about a company or a government. But it’s a BETTER story, a novel rather than a short story.”

The inverted yield curve is a better indicator of the economy’s health than any given down turn in the stock market. As short-term bonds have increasingly higher yields than long-term ones, investors are essentially saying that the short run is looking riskier than the long run, and therefore yields should be higher in order to compensate for the higher risk (i.e., there is most likely a recession landing in about two years’ time).

That may seem like a whole lot of economic jargon, but in reality, the track record for inverted yield curves and recessions in the U.S. and the United Kingdom is rather uncanny. All of the recessions in post-war America have been preceded by an inversion in the yield curve about two years prior. That is cause enough for serious concern.

Truthfully, it is incredibly difficult to discern the exact cause of this phenomenon. All we can do is infer plausible causes and make judgments on them on a case-by-case basis. What we do know is that the temporary inversion in the yield curve means that there is some sort of short-term uncertainty in the market. Most likely, it is a combination of factors all impacting the market. Global growth is down: Germany is nearing a recession with a shrinking economy and Argentina's stock market lost about half its value in a few days. Pair this with the ongoing trade tensions between the U.S. and China and a looming disaster brewing in the United Kingdom due to the possibility of a “No-Deal” Brexit, and it all points to a murky short-term future for the global market.

It is also somewhat possible that there is a self-fulfilling aspect of this warning. After all, the inverted yield curve does not cause a recession; it merely acts as a historic signifier of one. Warnings of a looming downturn could influence stakeholders to respond accordingly by saving more and spending less, which in turn slows the economy and thus we have the very thing we feared would happen anyway. It should be noted that while this inversion has occurred before every recession, the sample size for this indicator is still rather small. The outcome is not guaranteed, but it is reasonably probable — we ought to take the warning seriously all the same. 

President Donald Trump has tried diverting much of the attention away from the warning signs, tweeting recently that “the Democrats are trying to ‘will’ the economy to be bad for purposes of the 2020 elections” while also attacking the Federal Reserve for not keeping interest rates lower. Unfortunately, there is no evidence that the Fed’s interest rates have much to do with this phenomenon, and it is unlikely the Democratic party possesses the will to impact global markets in such a way.

Regardless of possible causes, everyone attending a university should be paying close attention over the next year or so. Great resources include keeping up with news sources such as The Economist, The Wall Street Journal or the Financial Times that all cover the economy in detail (and all have some sort of student discount available). Another tool to stay educated is social media. Find and follow a few economists to stay up to date.

If the inversion of the yield curve is correct again that means a recession is just two short years away. Which, by my math, means it will hit as most of us currently attending the University of Michigan are graduating. Securing a job can be hard enough after getting your diploma. Let’s hope we don’t have to do that in the midst of a new recession too.

Timothy Spurlin can be reached at timrspur@umich.edu.