Measuring the Potential of US Recession from Inverted Yield Curve

Penulis: Amal Ihsan Hadian

Editor: Yura Syahrul

11/12/2018, 00.07 WIB

Since 1955, the inverted yield curve of US government bonds has proven to be an accurate indicator of a crisis.

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Concerns over recession in the United States (US) emerged after the US government bonds experienced an inverted yield curve. This happened for the first time in the last ten years. The problem is that the inverted yield curve has proven to be an indicator of a recession. Will the recession really occur and how will it affect Indonesia?

Last week, the New York Stock Exchange and Nasdaq indexes fell after five-year and three-year treasury bond yields experienced an inversion. An inverted yield curve is when the yields on short-term bonds are higher than the yields on long-term bonds. This phenomenon previously happened in 2007, ahead of the 2007-2008 financial crisis.

Since 1955, the inverted yield curve has proven to be an indicator of a crisis. The 10-year and two-year treasury bond yields are often used as benchmarks. Last week, three-year and five-year US government bonds experienced an inversion. The spread has been below zero percent as the three-year bond yield has exceeded five years.

Many analysts predict the two-year and 10-year bonds will experience the inverted yield curve at the end of 2019. This phenomenon follows the downward sloping trend of the spread of the US government bonds from various durations (tenor) in the last three years, starting from bonds with duration close to each other, such as between the three-year and five-year bonds.

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Stock traders on the New York Stock Exchange (NYSE) in Manhattan, New York City, US, Wednesday (12/21). (ANTARA FOTO/REUTERS/Andrew Kelly)

The three-year and five-year bond yields had experienced an inversion in August 2005, about 28 months prior to the financial crisis. Under normal conditions, bonds with longer duration offer higher yields. This is in accordance with the concept of time value of money: the longer the investor awaits the maturity date of the bond, the higher the yield obtained.

Bond yields decrease when the price of the bonds rises due to high demand in the market for that bonds. In other words, investors are currently busy buying long-term US treasury bonds. As a result, the bond price rose and its yield fell. The opposite condition occurred in short-term bonds, where its price fell and the yield rose because of higher supply.

There are several reasons why this can happen. First, the policy of the US Central Bank, The Federal Reserve, to streamline its balance sheet. “The Fed’s previous policy was to conduct quantitative easing, and now with tapering off, the most instrumental in disrupting bond yields,” economist of Jefferies Financial Group Thomas Simons said, as quoted by Reuters.

During the 2007-2008 financial crisis, the Fed decided to inject liquidity into the market and reduce long-term debt interest by buying bonds issued by the US government and financial institutions. The policy referred to as quantitative easing is expected to pump up liquidity and drive growth.

The Fed saw the condition of the US economy began to improve in 2013. Therefore, it began to reduce the purchase of debt securities. This is called tapering off. The policy of buying long-term bonds finally stopped in October 2014. Seeing the improving economic conditions, the Fed began a program to streamline its balance sheet by releasing its debt securities in October 2017.

The value of the bonds was initially US$ 6 billion. At its peak, the Fed eventually issued bonds worth US$ 50 billion a month. Financial market investors were initially enthusiastic about buying bonds issued by the Fed, so it raised demand for long-term bonds. In the end, the price of long-term bonds soared and its yield fell.

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