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Economy on red alert with yield curve close to inversion
With yield curves close to inverting in the US and UK, Keith Wade, Chief Economist, explains the implications for the economy.
Both the US and UK yield curves are on the verge of inverting.
The yield curve has been a reliable predictor of US recessions over the last four decades, less so in the UK. With only one exception, each time the yield curve has inverted, the US economy has entered a downturn within 18 months.
What is the yield curve?
The yield curve is the difference between the interest rate on a longer-dated bond (debt issued by a corporation or country) and a shorter-dated bond.
For instance, typically it should cost less to borrow money for two years than for 10 years. This is because the economy is expected to grow over time and experience inflation. A healthy yield curve should therefore slope upwards.
What happens when it doesn’t?
When it costs more to borrow money in the short term than it does in the long term, the yield curve inverts or slopes downwards.
At best, an inversion suggests that investors expect the economy to slow, at worst it signals a recession could be on the way.
Why does the yield curve matter?
Keith Wade, Chief Economist said: “The curve is moving around at the moment, but we are close to if not inverted in both the US and UK.
“The US curve is a reliable indicator of recession, the UK curve less so.
“Nonetheless, if the US goes into recession it is hard for others not to go the same way given its importance as a driver of the world economy. So the double signal is important.
“There is normally a lag of about one year from inversion to recession so the curves are signalling problems for 2020.
“That said the UK has enough troubles in the near term having already experienced one quarter of contraction in the economy in Q2 2019 and facing the prospect of a hard Brexit in Q4 2019.
“The yield curve is saying that any post Brexit bounce in growth is likely to be short lived in the UK – food for thought for the government’s general election strategy and the Bank of England which continues to hint at raising rates.”
The chart below shows the difference between 2 and 10 year government bond yields in the US and UK which creates the yield curve. The figures shown are as at the end of the day. The UK yield curve inverted during the day on 14 August 2019.
US and UK yield curve
Source: Schroders. Refinitiv data for the US and UK 2 and 10 year bond yields correct as at 14 August 2019. Past performance is no guarantee of future returns.