An inverted yield curve is considered as a robust early warning indicator of an upcoming economic recession. Technically speaking, a yield curve is inverted when short-term interest rates yield more than longer-term rates.
Typically, a yield curve is supposed to slope upwards reflecting the fact a bond with a longer maturity should pay a higher yield than the same bond with a shorter maturity. The word ‘normal’ is being used in general terms: a bond with a longer term carries a greater degree of uncertainty than a bond of a shorter term as there is a greater the likelihood that something unexpected could take place over a longer period.
And, to offset this significant uncertainty a higher risk premium (i.e. a higher interest rate) is being offered to the investor. The added-value of a yield curve is that it shows how yields change as the maturity date becomes longer.
In other words, the inclination of the yield curve (namely the yield difference between the short-term maturity bonds and long-term maturity bonds) is regarded as an easy to understand predictor of GDP growth.
The criterion is that an inverted yield curve (short-term rates greater than long-term rates) provides an indication of an upcoming recession in the next twelve months. To put it into a broader perspective, a flat curve portrays an anaemic economic growth and, conversely, a steep curve shows robust GDP growth.
Bellweather for Recession
An inverted yield curve does not, on its own, trigger an economic recession. Rather, the process in which the yield curve is a part, can cause a recession.
According to U.S. research conducted by the Federal Reserve Bank of Cleveland as well as by the Auburn University, all eleven recessions of the postbellum era that took place in the United States were heralded by yield curves that were inverted.
And since 1945, all but one of the inverted yield curves that were observed for minimum a quarter led to economic recessions with an average lead time of 12-15 months. Indeed, the exception confirming the rule was the 1953 recession: while there was no inverted (or humped) yield curve, the yield curve flattened during the previous period.
Presently, the following emerging market countries are currently suffering from a sovereign bond inverted yield curve: Russia, Turkey, Venezuela, Mexico, India, China (i.e.,. it is currently flat, but it inverted a couple of months ago) . Out of these six, two warrant particular attention as their circumstances are unique in nature.
Granted, when displaying these countries, one needs to also take into account the effects of monetary policies of the central banks of these countries. For example, if a central bank fears a risk of heightened inflation in the country and thus wants to slow down the local economy, it will resort to pushing up short-term interest rates.
It will do so through drastic sales of short-term securities, thereby inundating the securities market, and as a result driving down the prices of these securities (and concomitantly increasing their yields).
So, when taking some of these countries that are blacklisted, China’s inverted yield curve (back in May 2017 as now in July the curve has flattened) would most likely be the result of monetary policy.
Indeed, the People’s Bank of China is trying to discourage the use of leveraged instruments whereby borrowed money is used for bond investments. In other words, the inverted yield curve is the result of Beijing’s policy to crackdown on new off-balance-sheet investments.
Ironically, while in a common environment an inverted yield curve is most of the times looked upon as a signal for an upcoming economic recession (look at the U.S. case since 1945), four out of six of these emerging markets still show that their equities markets are performing well.
What an Inverted Yield Curve Shows
To put it differently, if an inverted yield curve would imply a negative outlook on the GDP growth of a country, what would be the reason that four out of six of these emerging market countries are showing off with equities continuing to gain?
As already illustrated in the case of China, if the inverted yield curve is merely temporary, it can be caused by the fundamental law of supply and demand or paper-specific reasons. And, a short-term inversion may also portray an adjustment to an increasing interest rate environment.
Equally, for the case of Russia, India, and Mexico, these three countries do not seem to present major reasons for alarm at this point with their respective equity markets performing well.
The effects of Politics: Turkey and Venezuela
However, for Venezuela and Turkey, the story is a bit different. Both countries are coping with political instability (right, for Venezuela the case is way worse than for Turkey) due to political changes. In Turkey, as President Erdogan is curtailing more and more rights and powers away from its opposition (be it political parties, judges, and courts, media, human rights associations, educational authorities, security, etc.) and the risk for the establishment of an authoritarian regime looks greater by the day.
And compounding that risk is the resurgence of a civil war against the Kurdish citizens as well as the fact that Turkey is neighbouring Syria that is prone to a major unrest and civil war.
As for Venezuela, the country’s political crisis continues to worsen, and the social and economic situation is harsh as hunger and crime continue to soar, and the risk of an all-out civil war is rising. Caracas has imposed a state of emergency, and its citizens are suffering tremendously; not just from the violence but also the lack of access to basic food and medicines.
The last word is about China: as already mentioned the cause for the inverted yield curve in the country was mainly because of investors’ transient response to limited liquidity (i.e. itself the result of actions by Chinese regulators in attempts to fight the threat of shadow-banking). And, while because of that some might be tempted to brush away the risk of an upcoming recession, the country itself remains very much challenged by an unhealthy credit risk environment (See the previous article on the subject).