📉 Economic Recession: Coming Soon?
A yield curve inversion has been making international headlines. But what exactly is it and should we be panicking? (Reading Time: 4 mins)
The global economy is like a soufflé (or any other complicated pastry or cake you can think of).
For it to rise, everything needs to be just perfect.
If even one thing goes wrong, the economy just like the soufflé collapses, leaving a bad taste in all our mouths.
So, economists are constantly on the lookout for something that may upset the economy.
And they've found something alarming: an inverting yield curve.
A Blip on the Graph
Looking at the downward slope on these graphs?
That's what yield curve inversion is.
And this slope has gotten everyone worried about a recession.
Why?
To understand that, let's begin from the beginning: Understanding what a yield curve is.
What is a Yield Curve?
Governments borrow money through financial instruments called bonds. Now, the interest rates of these bonds usually remain the same. The difference in your returns or what is called the "yield", comes from the prices.
For instance: A 5% interest rate on the face value of Rs. 100 bond will always give you Rs. 5 as interest every year, regardless of its price. But say the price of the bond in the market becomes Rs. 90. You can effectively buy a Rs. 90 bond to get Rs. 5 interest, which is technically said to be a “yield” of Rs. 5 / Rs. 90 = 5.55%).
A yield curve plots the yields of the different long term and short term bonds.
Now, a long term bond, usually one that has a duration of 10 years or 30 years, is expected to give you a higher yield.
Why?
Because by investing your money for that long a period, you open yourself up to more risk.
What if inflation increases more than you had imagined?
To incentivise people to put their money in the bond market for longer, they are given higher yields than buyers of short-term bonds.
So, the yield curve is usually supposed to be an upward graph.
But right now in the US as we can see, it is going down.
This means that the gap between short term bond yields and long term bond yields is declining.
And five-year bonds already cost more than 30-year bonds!
This is called a yield curve inversion.
Okay, so what is the big deal?
The big deal is that this yield curve inversion usually is an indicator of recession.
Yes, this chart which resembles an ECG does actually measure the pulse of the economy. And a low point could signal a heart attack.
The 10-year 2-year bond yield curve (Fig.1), which is nearing zero is an excellent predictor of recessions. Almost every time that graph goes below zero, it indicates an upcoming recession.
It has so far predicted 10 out of the last 13 recessions.
So, obviously, economists are concerned.
But wait, how does the yield curve predict a recession?
Okay, so like we said people usually expect a higher yield on long term bonds than on short term bonds.
But if the yield curve is inverting it means that they are okay with lesser yields in the future also.
And why would anybody be okay with lesser yields?
Because they think the economy is going to be in trouble later and they want the security that bonds offer.
So, they buy more long term bonds, increasing their prices and decreasing yields.
And in believing that the economy is in trouble, they do end up causing some issues.
How?
You see, banks in general borrow short term bonds and lend long term bonds. They make money by pocketing the difference in yields. But if people's beliefs have caused long term bond yields to be less than short term bond yields, banks can't make money.
This could put them at risk of collapse, which could trigger a recession in the entire economy.
Okay, but why do people believe that the economy will slow down?
You see, the Federal Reserve (the US' central bank also called Fed) has recently raised interest rates by 0.25% after 3 years because inflation is at a 40-year high. It plans to further increase interest rates 6 or 7 more times this year.
This rise in interest rates coming just as the economy is recovering from Covid could slow down growth. Plus, thanks to the ongoing war the prices of oil and other commodities are rising, which could further add to this slowdown, leading to a recession.
The last time a recession hit the US in 2008, the Dow Jones lost half its value, the US GDP fell by 4.3% (the steepest decline since WWII), unemployment increased and didn't return to normal levels for 8 years, and people's median household income also decreased.
But how does it impact us all the way in India?
Well, the US is the centre of the global economy. Anything that happens there shakes up the whole world.
In 2008, our merchandise exports fell by 30% and our GDP fell from 9% to 7.8%.
Something similar could happen this time as well.
So, is it time to start panicking?
Well, no.
Firstly, the yield curve inversion is an indicator that people are worried about the economy. It does not guarantee a recession. In fact, it did cause a false alarm in 1998.
Secondly, the 10-year/3-month bond yield curve is actually doing quite well.
This curve is a much better indicator of recession, according to economists like Fed Chairman Jerome Powell.
Thirdly, the yield curve inversion could just be the result of a distortion and shouldn't be trusted. Huh?
You see, the Fed had been keeping interest rates low and injecting money into the economy by buying long term bonds to help people get easy money during Covid. This process is called quantitative easing. But as the Central Bank was buying lots of long term bonds, prices increased and yield decreased.
So, this artificial decrease in yields could be behind the yield inversion.
But just in case, it is not a false alarm (several banks seem to think it is not; JP Morgan has predicted that chances of recession are 30%-35%, much higher than the historical 15% average), you still have somewhere around 12-24 months to prepare for an upcoming recession.
So, you can increase savings, reduce spending, and invest in safe assets like gold to be prepared.
But no matter what the reality is, the yield curve inversion has led to serious worries across the world. The Fed now needs to tread very carefully, rethinking each interest hike.
All we can do is wait and watch.
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