The U.S. economy is currently in great shape. Unemployment is historically low
, wages are high
and GDP growth
has beaten most of the world’s leading economies for some time now. To top it off, 76 percent of S&P 500 companies who reported their first quarter earnings by mid-May beat average earnings per share estimates. But some clouds are gathering on the horizon. As the trade war with China drags on and President Trump looks determined to open another front by imposing tariffs on Mexican imports, economists are increasingly worried that the tariffs could drive up consumer prices, stifle demand and weigh on corporate investment. Aside from the uncertainty associated with the ongoing trade disputes, there’s one more ominous sign though, signaling that the current expansion might soon be coming to an end: the (partially) inverted yield curve.
The yield curve shows how much it costs the federal government to borrow money for a given amount of time, revealing the relationship between long- and short-term interest rates. It usually slopes upward, meaning that the yield is higher the longer your money is tied up, reflecting the fact that long-term investors bear a higher risk. If the yield for bonds with short maturity exceeds the yield for longer-term bonds, this is called an inverted or partially inverted yield curve, which is what we’re currently seeing. On June 5, the yield on 10-year Treasury bonds closed at 2.12 percent, close to Monday’s 20-month low of 2.07 percent. Meanwhile a 30-day Treasury bond is yielding 2.31 percent, meaning that short-term lenders receive a higher yield than those tying up their money for 10 years.
So what does that mean? “The term spread—the difference between long-term and short-term interest rates—is a strikingly accurate predictor of future economic activity”, Michael D. Bauer and Thomas M. Mertens found in a 2018 Federal Reserve research paper
, adding that “every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve”. So should we all be bracing for an imminent recession? Not quite. The current inversion is relatively shallow with the spread between the 10-year and the 3-month yield standing at -0.23 percent. According to the New York Fed
that translates to a 30 percent risk of a recession occurring within the next 12 months, which is substantial but far from a certainty.