Yield Curve Inversion and Macroeconomic Indicators: Crisis or Opportunity?

Today, let's examine the yield curve inversion, one of the key indicators of the U.S. economy, and its correlation with various macroeconomic indicators.

1. What is the U.S. Treasury Yield Curve?

First, let's look at the definition and meaning of the yield curve. The yield curve is a graph that shows the yields of U.S. Treasury bonds with different maturities. Considering the term premium, long-term bonds typically have higher yields than short-term bonds. Therefore, in normal economic conditions, the curve slopes upward. This is because investors demand higher compensation for longer-term investments (Term Premium).

(Data Source: Daily Treasury Par Yield Curve Rates, US Department of the Treasury)

The graph above shows the U.S. Treasury yield curve as of August 30, 2024. Unlike a normal curve shape, it shows an abnormal inverted state. In other words, short-term yields (1 month to 1 year) are higher than long-term yields (2 years to 30 years). There are several reasons why such a yield curve inversion occurs:

• Recession concerns: This occurs when investors expect the economy to be robust in the short term but anticipate a recession in the long term. This increases demand for long-term bonds, lowering long-term rates.

• Monetary policy impact: This phenomenon appears when the central bank (Federal Reserve) maintains high short-term policy rates to curb inflation. Currently, the Fed's policy rate is 5.25% - 5.5%, and short-term U.S. Treasury rates align with this.

• Preference for safe assets: When economic uncertainty increases, investors may prefer safe long-term government bonds, causing long-term rates to fall.

• Global factors: Economic conditions or policies of other countries can affect the U.S. bond market. For example, China's central bank is reducing its U.S. Treasury holdings due to U.S.-China tensions, which can affect U.S. Treasury supply and demand, influencing yields.

2. The Meaning of Yield Curve Inversion

Yield curve inversion refers to the phenomenon where short-term bond yields become higher than long-term bond yields. It's typically judged based on the difference between 2-year and 10-year Treasury yields. Historically, yield curve inversion has been seen as a precursor to economic recession. However, this isn't always the case, and it should be interpreted comprehensively along with other economic indicators.

(Data Source: FRED, Federal Reserve Bank of St.Louis)

The graph above shows the difference between 10-year and 2-year U.S. Treasury yields from 1980 to the present, along with U.S. recession periods. Shaded areas indicate U.S. recessions. When the blue line goes below the red baseline of 0, it indicates that the 2-year yield is higher than the 10-year yield, signifying a yield curve inversion. As shown in the image, recessions typically occurred within 6-24 months after a yield curve inversion.

Currently, we can see that the yield curve inverted around 2022 and is now normalizing, hitting 0 recently. If we learn from history, this strongly suggests that the U.S. economy could enter a recession within the next 6 months to 2 years. Of course, it doesn't always lead to a recession, and it should be interpreted comprehensively along with other economic indicators. The duration and degree of the inversion are also important considerations.

3. The Impact of Yield Curve Inversion on Markets

To understand how yield curve inversion typically affects stock, bond, foreign exchange, and housing markets, we've extracted and compared data.

(Data Source: FRED, Federal Reserve Bank of St.Louis; Yahoo Finance)

The graph above shows the relationship between the yield curve spread and the S&P 500 index. There's a tendency for the S&P 500 index to rise before a yield curve inversion occurs, and the stock market tends to decline after the inversion. This suggests that yield curve inversion acts as a signal for future economic recession.

(Data Source: FRED, Federal Reserve Bank of St.Louis; Yahoo Finance)

The second graph shows the relationship between the yield curve spread and the 10-year Treasury yield. While the 10-year Treasury yield shows a continuous downward pattern reflecting the trend from the high-interest rate era of the 1980s to a lower interest rate environment, we can see that the 10-year Treasury yield tends to drop sharply during yield curve inversion periods. This reflects the phenomenon of investors investing in long-term government bonds in anticipation of a recession.

(Data Source: FRED, Federal Reserve Bank of St.Louis; Yahoo Finance)

The third graph shows the relationship between the yield curve spread and the Dollar Index. Interestingly, when the yield curve inverts (when the spread is negative), the Dollar Index tends to rise. This reflects the increased demand for the dollar as a safe-haven asset when recession concerns grow.

(Data Source: FRED, Federal Reserve Bank of St.Louis)

The last graph shows the relationship between the yield curve spread and the U.S. housing price index. Interestingly, housing prices tend to continue rising even after a yield curve inversion. This suggests that the real estate market may react more slowly to economic cycles than other economic indicators.

4. Conclusion

Yield curve inversion serves as an important signal for the U.S. economy. Through the data analysis above, we could confirm a series of processes where yield curve inversion leads to dollar strength, bond yield decline, stock market correction, and ultimately recession. However, it's worth noting that the housing market shows a somewhat delayed reaction.

Currently, the U.S. economy is showing signs of recovery after the yield curve inversion, with the stock market having risen significantly, and bond yields and the dollar declining after hitting short-term highs. It's important to refer to the lessons of history to predict how the market will move in the future. However, just as the man who has fed the chicken every day throughout its life at last wrings its neck instead, predictions based on induction can betray our expectations at any moment. Accurately predicting the market is a very difficult task and should be considered comprehensively along with other economic indicators such as prices and employment.