This post originally appeared on The Basis Point: 2020 Recession Watch & Yield Curve 101 – w Heidi Moore & Josh Brown
You might have noticed people freaking out about a 2020 recession and something called an inverted yield curve on Twitter.
Wait, what?! I thought the economy was doing great!
It’s true jobs, incomes, and economic growth have been doing well, but bond investors are worried our luck is running out.
So they’re buying bonds as safe bets, and pushed long-term rates in the economy below short-term rates this week. This is called an inverted yield curve, and it means a recession could be coming.
Did that make zero sense?
Then let’s break it down to see if the good economic times are over.
YIELD CURVE 101
Unlike most stocks, a bond pays investors a fixed rate of return (aka yield) each year.
Yield is a synonym for rate of return on bonds, and the “yield curve” of rates in the economy normally slopes up. Makes sense. You’d expect more return from a longer term bond investment than a shorter term one, right?
But when the economic outlook darkens (trade wars, slowing growth, etc.), global investors pile into longer term bonds like 10-year and 30-year Treasuries. These are safe government-backed bonds, so they’re a better way than stocks to ride out uncertainty.
Long-term bond prices rise when this mass buying happens, and rates (aka yields) drop.
Long-term bond buying has been so strong lately (as investors hedge against their gloomy economic outlook), 10-year bond rates dropped below 2-year bond* rates yesterday (chart below).
This inverted the yield curve for a moment, and stoked recession panic.
This is a very basic yield curve explanation, and for a super clear yield curve lesson, I refer you to this thread by Heidi Moore, a veteran WSJ alum and OG of finance Twitter.
Okay who wants a plain-language explanation of the inverted yield curve? I will do it if there's demand.
— Heidi N. Moore (@moorehn) August 14, 2019
Anyone who lived through the financial crisis as a bill paying adult knows what a recession feels like.
Massive job losses and/or pay cuts, companies closing left and right, and the resulting household belt tightening.
When investors are uncertain, they buy long-term bonds and drive rates down as noted above.
If companies are uncertain, they trim staff, salaries, and/or growth plans.
And if we’re uncertain, we worry about our job and income prospects, and spend less.
This three-part cycle can become self-fulfilling.
Right now companies are seeing investors invert the yield curve.
So they may make cautionary payroll and job cuts, which could cause us to make our own cautionary household spending cuts.
And since consumer spending is about two-thirds of economic growth (GDP), the economy could slow.
Poof, a recession.
Which can generally only be defined after it’s already here.
RECESSION 2020 OR NOT?
There are “official” definitions of recession, like GDP contracting for 2 quarters.
But nobody really owns that definition.
The most official recession definition comes from the National Bureau of Economic Research (NBER), and its incredibly broad:
“A decline in economic activity, spread across the economy and lasting more than a few months.”
Plus the NBER’s recession calls are always made after the fact.
Like WAY after.
For the last recession, the NBER announced in December 2008 that the recession had begun in December 2007.
Gee thanks, NBER! I didn’t know the whole world was melting down for the past year!
To be fair, their definition does say they’re looking at all the key things: GDP, income, employment, industrial production, and wholesale/retail sales.
But these things are backward looking whereas the market tries to be a forward-looking mechanism.
Hence the bond market inverting the yield curve this week.
As for GDP, here’s a chart on the latest. Not so bad, but that last line showing 2.1% 2Q GDP growth declined a full 1% from Q2.
And this 2Q number will get revised again two weeks from today on August 29.
I’ll do another update on 2020 recession watch then.
In the meantime, don’t miss links below from Ritholtz Wealth Management CEO Josh Brown and research head Michael Batnick on what you should do when it comes to all this heady stuff.
The answer is simpler than you think.
– * One technicality on naming: all fixed income instruments across the yield curve behave similarly in that they offer a rate of return, but there are three technical names used in government fixed income circles: Bills mature in one year or less, Notes mature between 2 and 10 years, and Bonds mature in more than 10. For the purpose of simplicity in this piece, we call them all bonds. Making this note so the nerds know we’re on it.