The Inverted Yield Curve and Recession

Updated on August 28, 2019
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Mike has a keen interest in the effects of politics in our culture. He has a unique way of simplifying complex concepts.

There are many forces that can contribute to a recession, including the downturn of the Gross Domestic Product (GDP), the trade deficit, and the labor force participation rate.

Historically, the treasury bond inverted yield curve has served as an indicator of a future recession. However, economists are mixed on their views as to whether or not a recession will occur in the near future. This article describes how these forces have worked in the past to predict and create a recession and how current indicators show the possibility of it happening again.

The sources for this article are from the following:

  • Bureau of Labor Statistics
  • Bureau of Economic Analysis
  • The Federal Reserve Board of St. Louis Missouri

What Are Treasury Bonds?

Treasury bonds are financial securities that are used to loan money to the U.S. government to pay for a wide range of federal government activities. A large part of the national debt is made up of outstanding treasury bonds.

Short-term bonds are called T-Bills. Long term bonds are called T-Bonds and T-Notes. Short term T-Bills are issued with a maturity of 3 months, 6 months, and 1 year. T-Notes have a maturity of 2 to 10 years. T-Bonds have a maturity of over 10 years. The table below gives a summary of each type of bond and their terms to maturity.

Type of Bond
Maturity Period
Trading Amount
T-Bills
3 months, 6 months, 1 year
$10,000 up to $1 million
T-Notes
2 Years to 10 years
$1,000 up to $1 million
T-Bonds
Over 10 Years
$1,000 up to $1 million

What Is a Bond's Yield?

In general, a bond's yield is a measure of a bond's current value based on the difference between the price paid for the bond and the interest received. Since long-term bonds are more of an investment risk than short term bonds, they normally have a greater yield than short term bonds. This is because bondholders demand a higher yield to compensate for tying up their money for longer periods of time. Bond yields that are charted over a period of time form a bond yield curve.

What Is a Bond Yield Inversion?

When the yield curve for short term bonds is higher than the long-term bonds it is called a yield curve inversion. Currently, the short term 2-month T-Bill yield is above the 10-year T- Bond yield. When money is moved out of the stock market into the less risky bond market, it is called a flight to quality.

Normally, more money is invested in long-term bonds, thus increasing their yield curve. However, when indicators point to a downturn, more money is invested into less risky short-term bonds, thus increasing their yield curve.

The chart below shows the yield curve inversion for the month of August 2019. The 10 year bond is shown in gold and the 2 year bond is shown in purple. The first inversion was on August 14th and the second inversion was on August 22nd.

What Is the Official Definition of a Recession?

According to the Bureau of Economic Analysis, a recession is defined as a contraction in the Gross Domestic Product (GDP) for six months (two consecutive quarters) or longer, marked by high unemployment, stagnant wages, and a fall in retail sales. A recession generally does not last longer than one year and is much milder than a depression.

The GDP Versus the 10 Year Note

The below chart shows the following, starting from 1980 in five year increments until present.

  • The 10 Year T-Note in blue
  • The Gross Domestic Product (GDP) in red
  • Recessions in vertical shaded bars.
  • The horizontal line is the zero axis.
  • The left side scale is the year-to-year percentage of change for both the bond and the GDP.

Notice after the 10 year note went below zero, the GDP also went negative and four recession occurred shortly thereafter.

What Is a Trade Deficit?

A trade deficit (balance of trade) occurs when a country spends more for imports than it earns on its exports. A negative balance of trade in the short term has the effect of curbing inflation. But over time, a substantial trade deficit weakens domestic industries and decreases job opportunities. A huge reliance on imports also leaves a country vulnerable to economic downturns. Currency devaluations, for example, make imports more costly, thus stimulating inflation.

At present, the United States holds the record for having the largest trade deficit in the world. This distinction has been held since 1975, according to the Federal Reserve Board on Economic Data (FRED)

Trade Deficit Graph from June 2017 to June 2019

The U.S. monthly international trade deficit decreased in June 2019 according to the U.S.Bureau of Economic Analysis and the U.S. Census Bureau. The deficit decreased from $55.3 billion in May (revised) to $55.2 billion in June, as imports decreased more than exports. The previously published May deficit was $55.5 billion. The goods deficit decreased $0.8 billion in June 2019 to $75.1 billion. The services surplus decreased $0.6 billion in June 2019 to $20.0 billion. The blue line is the the monthly deficit and the orange line is the three month moving average.

Contrary to what President Trump has been stating, we as the importer pay the tariffs, not the exporter. That is, we pay the 32 billion in tariffs, not China. This will most certainly have a ripple effect throughout our economy and can lead to a recession as well. Further, he wants to increase those tariffs.

Unemployment Rate Versus Labor Force Participation Rate

Presidents like to quote the unemployment rate, which is currently at 3.2%. However, a more accurate indicator for the labor market is the Labor Force Participation Rate (LFPR). The LFPR is calculated by adding the number of people over 16 years of age who have jobs with the number of people who are still looking for jobs in the last four weeks and dividing that sum by the total population of those over 16 years of age.

The current labor force participation rate is 67%. That means out of the total work force population there are still 33% who are not participating in the labor market. This could also contribute to a recession. Below is the formula for calculating the current Labor Force Participation Rate (LFPR).

After reading this article, do think a recession is imminent?

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Do you think a trade war with China can cause a recession?

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Questions & Answers

    © 2019 Mike Russo

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