What to make of an inverted yield curve

For the last 50 years, the U.S. yield curve has inverted before every recession. So with the yield curve on the two- and 10-year Treasurys briefly inverting last month, it’s no surprise that investors are fearing a recession may be on way.

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The yield on three-month Treasurys rose above the 10-year earlier this year.

“We’re already in the later innings of the economic cycle,” said Amber Sinha, senior portfolio manager, global equities at CIBC Asset Management, in an Aug. 21 interview. “We’ve had an expansion going more than 10 years now, so people are certainly a little cautious. And an inversion in the yield curve makes people even more cautious.”

An inverted yield curve is cause for concern because it shows investors are willing to accept lower returns for tying up their money in long-term government debt than they’re getting for short-term loans.

“With more time comes more uncertainty and, as a result, you’d expect people to want a higher return when they lend money over longer periods of time,” Sinha said. “A normal yield curve should be upwards sloping.”

That means the interest rate for two months should be lower than for three years, which is lower than five years, which is lower than 10 years.

“The spread between the two- and 10-year bonds is approaching zero,” he said. “If we were to see this spread go into deeper negative territory and last for long, that would definitely be a little bit more of a serious situation in the market.”

An inverted curve doesn’t mean a recession will happen right away, though.

“It could still take anywhere from a few months to a couple of years for the actual recession to set in,” Sinha said. “On an average, it takes 18 months from the inversion of the curve to the onset of the recession.”

More recession indicators

Sinha noted than an inverted yield curve isn’t the only sign of recession.

“You’d see stresses in the credit market,” he said. “We don’t see that right now. You’d see stresses in the labour market. You don’t see that right now. Unemployment across industries, across demographics is at multi-year, multi-decade lows.”

U.S. unemployment was at 3.7% in July, while Canada’s unemployment was 5.7%.

The manufacturing sector is another area to watch. While Sinha noted there has been a global slowdown, the sector wasn’t “stressed right now.”

The U.S. Institute for Supply Management’s (ISM) manufacturing index was at 51.2 in July, the lowest reading since August 2016, Reuters reported. If it slips to lower than 50 over an extended period, it means the economy is contracting, according to ISM.

“Even if a recession is around the corner, [we don’t know] when exactly it’s going to happen,” said Sinha. “We wouldn’t just look at an inverted yield curve and go to cash, and not invest any further.”

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