New York City: The stock market tumbled Friday as investors digested an ominous warning sign: Interest rates on long-term government debt fell below the rate on short-term bills. That’s often a signal that a recession is on the horizon.
The Dow Jones Industrial Average fell more than 460 points Friday, or about 1.8 percent. The broader S&P 500 index fell 1.9 percent.
Ordinarily, the yield on long-term debt is higher, just as 10-year certificates of deposit tend to pay higher interest rates than 3-month CDs.
Bond watchers get nervous when that typical pattern is turned on its head.
“We don’t see that occur that often, but when it does, it’s almost always bad news,” said Campbell Harvey, a professor of finance at Duke University.
That’s why warning lights started flashing Friday morning when the yield on the 10-year Treasury note slipped below that of the three-month bill. The last time that happened was just before the Great Recession.
Harvey’s been keeping a close eye on these rare, “inverted” yield curves for more than 30 years, and treats them as a kind of early warning signal.
“My indicator has successfully predicted four of the last four recessions,” he said, “including a pretty important call before the global financial crisis.”
Harvey won’t actually forecast a recession unless the yield curve stays inverted for at least three months. But even a flat curve — in which long-term yields are just slightly above short-term yields — could be an indicator the economy is losing steam.
“It might be that we dodge a recession, but the economic growth will be lower — much lower,” Harvey said.
On Wednesday, the Federal Reserve lowered its own forecast of economic growth, to just over 2 percent for the year and signaled that it was unlikely to raise interest rates in 2019.
Fed Chairman Jerome Powell said slowing growth in China and Europe present “headwinds” for the U.S. economy. And ongoing trade disputes are not helping. “There’s a fair amount of uncertainty,” Powell said.
The unemployment rate is at a low 3.8 percent, but the economy added only 20,000 jobs in February. That was far less than projected by economists and the smallest gain since September 2017.
What’s a yield curve?
It’s a way to show the difference in the compensation investors are getting for choosing to buy shorter- or longer-term debt. Most of the time, they demand more for locking away their money for longer periods, with the greater uncertainty that brings. So yield curves usually slope upward.
What are flat and inverted yield curves?
A yield curve goes flat when the premium, or spread, for longer-term bonds drops to zero — when, for example, the rate on 30-year bonds is no different than the rate on two-year notes. If the spread turns negative, the curve is considered “inverted.”
Why does yield curve matter?
The yield curve has historically reflected the market’s sense of the economy, particularly about inflation. Investors who think inflation will increase will demand higher yields to offset its effect. Because inflation usually comes from strong economic growth, a sharply upward-sloping yield curve generally means that investors have rosy expectations. An inverted yield curve, by contrast, has been a reliable indicator of impending economic slumps, like the one that started about 11 years ago. In particular, the spread between three-month bills and 10-year Treasuries has inverted before each of the past seven recessions.
What’s been happening with U.S. yield curves?
The flattening trend that took the market by force at the end of 2017 continued through 2018, as the Federal Reserve continued to raise short term rates. But in March, the central bank policy makers lowered both their growth projections and their interest rate outlook, with the majority of officials now envisaging no hikes this year. That’s down from a median call of two at their December meeting. Concern about a possible economic slump and the prospect of the Fed having to cut short-term rates led the yield gap between 3-month and 10-year yields to vanish in a surge of buying that pushed long-term rates sharply lower.