Any claim to the discovery of a reliable barometer in macroeconomic forecasting is often discarded, or, at best, held to suspicion and scrutiny. Indeed the old joke runs, an economic forecaster is one who can predict what will happen tomorrow, next month, next year, and then have the ability to explain later why it never happened. The ‘yield curve’, for reasons where consensus has yet been established, seems to have evaded such nasty connotations that come with forecasting. As a matter of fact, it has stood as a remarkably accurate predictor of economic recessions over many decades.
When tax receipts are insufficient, governments need to borrow to finance spending (for infrastructure, education, healthcare, defense). This they achieve by issuing securities in return for cash. Investors, who could be a firm or an individual, purchase these securities in hope for a return in the future above the principal amount. This return we broadly call the interest rate or ‘yield’. Now government securities mature at different lengths, meaning the terms of their contract (like that of a loan) end at different lengths. Short term securities, also called notes, mature after two to ten years, while longer-term ones, called bonds, mature after thirty years.
The yield curve, a graphical representation, plots a relationship between the interest rates of bonds (on the vertical axis) and their maturity period (the further right you are on the horizontal axis, the longer the maturity of the security). An upward sloping yield curve means longer-term bonds have a higher return than short-term notes. This is generally the case since investors who hold long-term bonds demand a higher rate of return over short-term securities mainly to compensate for the longer maturity period—a bank, for example, will charge higher interest for a longer-term loan. The yield curve also gives an indication of the confidence investors have on the overall health of the economy. If investors believe—and mind it, the word ‘believe’ here is crucial—an economic slowdown is to come soon, they will expect inflation to fall as well (lower output growth lowers employment which lowers labor market strength which lowers wages which lowers prices). This then brings down the interest rate on long-term bonds because investors are willing to accept a lower nominal return knowing that a fall in prices will keep the real rate of return more or less unchanged. And as the yield curve gets flatter—as lending out long-term, low-yield contracts while having to borrow short-term, high-interest contracts becomes less lucrative—banks are disincentivized to expand credit and create new loans thereby exacerbating or initiating a slowdown. When indeed the interest rate on short-term securities moves above that of longer-term ones, we say the yield curve has inverted.
In the last few months the yield curve of the United States, the world’s largest economy, has witnessed such an inversion. This is not to say, though, that an inverted yield curve always predicts correctly a recession. But every, and I mean every, recession has been preceded by an inverted yield curve. Given the hyper-connectivity of the global economy, a recession in the US, and especially one following a long and historic boom, will drag along the global economy to a significant slowdown. When America sneezes, the saying goes, the world catches a cold. Larry Summers has raised the likelihood of a recession within the next few months to equal the chances of there not being one. Such odds (50:50) warrant worry and action to a policymaker.
For emerging economies like India, yield curve inversions are rare, recessions even rarer. Much of this is because of differences in fundamentals. A poorer country is at a much lower point in output per-capita terms. Diminishing returns and the convergence hypothesis mean India’s economy will grow at a much higher rate than the U.S; a lot more catching up to do. Hence the potential to grow above 7% on average today appears to be reserved strictly for poor and middle-income countries. During global recessions, this average growth rate falls to 4% or so, nowhere close to zero. But such advantages shouldn’t be causes to revel. If the United States was to face a recession, demand for Indian exports by the United States will fall. To combat the recession the U.S central bank will cut short-term interest rates. Investors and speculators will see to this arbitrage and transfer their money from American markets into Indian equities (which bear higher short-term rates) and could likely spur Indian equity markets to overheat, and the rupee to appreciate, which will reduce demand for Indian goods and services further hurting exports.
The highly volatile trade relationship between the United States and China in recent months is another reason why investors have switched to panic mode. If no concrete agreement is reached soon and both sides continue with their juvenile behaviors of slapping the other with tariffs (a clear violation of intellectual rigor) the markets will conclude from this uncertainty a definite crisis to come.
The yield curve has for over 60 years remained faithful to economic forecasting, and there is little indication of it wanting to betray. The least we can do in return is to grant our attention, whatever the manner may be.
Author: Resem Makan
Resem Makan is an Economics PhD student at the University of Washington. Before this, he was at the Indian Statistical Institute (Delhi) where he studied Quantitative Economics. He grew up in Nagaland, Aizawl, and Shillong, and thus feels a part of everywhere.