[Insight & Opinion] Signals from US Treasury Yield Curve Inversion

Kyungsoo Kim, Professor Emeritus at Sungkyunkwan University

The world is currently focusing on the possibility of a recession in the US economy. A recession is typically defined as two consecutive quarters of negative growth. Official recessions, judged retrospectively, have occurred 11 times in the past 70 years.

The possibility of a recession arises when the yield (interest rate) on long-term government bonds is lower than that on short-term government bonds, i.e., when the yield curve inverts. Yield curve inversion is not a frequent phenomenon. Generally, long-term bonds have higher yields because the longer maturity means investors’ money is tied up for a longer period, which adds a term premium to the bond yield. Of course, it can also reflect expectations that interest rates will rise in the future.

Government bond yields provide important clues for predicting the future economy. Central banks’ tightening monetary policies in response to high inflation pressures raise current interest rates, but when a hot economy cools down, future interest rates fall. Yield curve inversion occurs from bond investors’ perception that the monetary policy’s ripple effects will be significant. A gloomy outlook for the future leads to a preference for safe assets, causing long-term government bond yields to fall, and concerns about an economic recession can be a factor behind yield curve inversion.

The predictive power of yield curve inversion is very high. Without exception, all official recessions were preceded by yield curve inversion with a lag of 6 to 24 months. However, there was one case in the 1960s where economic contraction occurred instead of a recession despite yield curve inversion.

Here, the question arises as to which indicator should be used to measure yield curve inversion. Researchers consider the difference between 10-year and 3-month government bond yields as the most predictive indicator. The media mainly cites the difference between 10-year and 2-year government bond yields. Currently, yield curve inversion has occurred between the 10-year and 2-year yields.

Recently, researchers at the US Federal Reserve (Fed) have proposed focusing on market expectations of the monetary policy path, similar to the first example explained, and suggested the difference between 18-month Treasury futures and 3-month government bond yields as a predictive indicator. According to this indicator, there are no signs of yield curve inversion. The Fed currently appears to trust this indicator.

Last week, the Fed released minutes including a quantitative tightening (QT) plan to reduce assets by $95 billion per month (government bonds and mortgage-backed securities) to shrink its $9 trillion balance sheet, along with aggressive interest rate hikes. The media immediately raised skepticism about whether this could be done without shocking the market.

Janet Yellen, then Fed Chair (now Treasury Secretary), likened the QT started in 2017 as part of monetary policy normalization after the global financial crisis to “watching paint dry,” but the securities and foreign exchange markets fluctuated. Eventually, in March 2019, both rate hikes and QT were halted. Moreover, when ultra-short-term interest rates surged from September of the same year, the Fed intervened massively in the market to calm the repo market.

The Fed, which surely has not forgotten this fact, insists on pushing forward due to inflation levels and a tight labor market that are incomparably higher than at that time. Lawrence Summers, Harvard University professor who made Paul Krugman of the City University of New York concede in the inflation debate, harshly criticized the Fed for writing a rosy scenario economics by forecasting a 3.5% unemployment rate and inflation in the 2% range over the next three years through appropriate monetary policy.

To gauge whether the Fed, criticized for its delayed response, will achieve a soft landing for the US economy, it is necessary to continuously monitor the signals sent by the US Treasury market.

Kyungsoo Kim, Professor Emeritus, Sungkyunkwan University

This content was produced with the assistance of AI translation services.