In inversion of US treasury yields, a recession is foretold

A recession typically involves the overall output in an economy contracting for at least two consecutive quarters, along with job losses and reduction in overall demand. The US National Bureau of Economic Research (NBER) decides whether the economy is in a recession based on its assessment of the depth, diffusion, and duration of the impact on the economy.

Sometimes, the duration may not be long but the decline could be very severe — as it happened in the wake of the Covid-19 pandemic. Or, the depth and diffusion may be relatively less but the downturn may last long — as is expected in the United Kingdom in the wake of the economic crisis triggered by the Liz Truss-Kwasi Kwarteng mini-Budget of September 2022.

What are US treasuries?

In any economy, the safest loans are those that are given to governments — entities that will always be there, and which typically do not default on their debt. Governments need to borrow money because their tax revenues more often than not aren’t enough to finance all their spending.

The instrument by which the government borrows from the market is called a government bond. In India they are called G-secs, in the UK they are called gilts, and in the US, they are called treasuries.

And what is the yield of a treasury?

Unlike a bank loan, on which the interest rate varies with time, a government bond comes with pre-determined “coupon” payment. So, the US government may “float” a 10-year bond with a face value of $100 and coupon payment of $5. This means, if you lend $100 to the US government by buying this bond, you would get $5 each year for the next 10 years plus the whole sum of $100 at the end of 10 years. This would imply a yield of 5%.

But if for some reason one sold this bond to another investor, the yield will change depending on the price at which the bond is sold. If the price increases — say, the bond is sold for $110 — the yield will fall because the annual return ($5) remains the same. And if the price falls, the yield will rise.

What is the yield curve?

Governments borrow for durations ranging from 1 month to 30 years. Typically, yields are higher for longer tenures because one is lending money for longer. If the yields for different tenures of bonds are mapped, it will give an upward-sloping curve (“Normal” in the chart above).

The curves can be flat or steep depending on the money available in the market and the expected overall economic activity. When investors feel buoyant about the economy, they pull money out of long-term bonds and put it into short-term riskier assets such as stock markets. As prices of long-term bonds fall, their yields rise — and the yield curve steepens.

What is yield inversion?

Yield inversion happens when yields for shorter duration bonds are higher than the yields on longer duration bonds. If investors suspect that the economy is heading for trouble, they will pull out money from short-term risky assets (such as stock markets) and put it in long-term bonds. This causes the prices of the long-term bonds to rise and their yields to fall.

This process first leads to flattening and eventually the inversion of the yield curve.

Yield inversion has long been a reliable predictor of recession in the US — and US treasuries have been witnessing yield inversion for a while now. The spread between the yields of 10-year and 3-month treasuries has turned negative.

Is all of this unexpected?

Not entirely. In its bid to contain historically high inflation levels, the US Federal Reserve has been raising short-term interest rates to curb overall demand and economic activity. Historically, every time the Fed has tried to bring down inflation by more than two percentage points, the US has witnessed a recession.
The Fed appears determined to bring down inflation to the 2% level, but despite rapid interest rate hikes — around 425 basis points — inflation has only moderated from around 9% in July to 7% in November.

Moreover, the economy grew by over 3% in the July-September quarter and continued to create hundreds of thousands of jobs, pushing up wages and keeping unemployment at historic lows. As such, even though the Fed has now started raising rates at a slower pace, it is expected that it will keep raising rates and stay at those higher levels for longer.

The more the Fed tightens its monetary stance, the more likely it is for the US economy to fall into a recession. That is what the yield inversion is showing.

Why does this matter to India?

It matters in several ways.

Rising interest rates are likely to make the US dollar even more strong against the rupee. Indian imports will become costlier as a result, and could fuel domestic inflation.

Higher returns in the US may also lead to some rebalancing of the investments coming to India.

Indian exports may benefit due to a weaker rupee but a recession will dampen the demand for Indian exports.

A slowdown or recession may, however, come with the silver lining of lower crude oil prices for India.