It is widely believed that an inverted US Treasury yield curve signals an impending economic downturn. Every recession since World War II has been preceded by an inverted yield curve. Of course, an inverted yield curve is just an expression of what investors think about the economic outlook, and as we all know, investors can be wrong. And since the financial crisis, markets have been so distorted by central bank policy that an inverted yield curve maybe doesn’t quite signal what it was. So maybe we shouldn’t be worried about the yield curve inversion.
Or – should we? A new blog post by the St. Louis Federal Reserve suggests that people might be right to worry about the yield curve inverting. And the reason is the behavior of the banks.
The US Treasury yield curve is said to be “inverted” when the yield on short-term bonds is higher than that on long-term bonds. Normally, investors expect higher yields on longer-term bonds to offset them for the higher risk of the bond. But if investors think the short-term economic outlook is bad, they can sell short-term bonds while holding on to longer-term bonds, increasing the yield on short-term bonds relative to that of longer bonds. term. This is why an inverted yield curve is often seen as an indicator of a coming recession.
The most widely used bonds to measure the slope of the yield curve are 2-year and 10-year bonds. So far the 2 vs 10 year curve has not reversed, even though it is very flat (the spread between bonds was only 0.2% on December 28). But in early December, according to another measure, the yield curve reversed: the 2-year UST yield briefly rose above the 5-year yield.
An inverted yield curve is terrible for banks. Indeed, banks make profits on the difference between their cost of financing and the return on their loans. When the yield curve is rising, they have an interest in borrowing short-term funds and lending long-term. This is called the “transformation of maturity”. Transforming maturity has always been at the heart of simple ‘boring’ banking, as the traditional saying of the British bank manager illustrates: ‘Borrow at 3%, lend at 6%, be on the golf course at 3 ”. But if short-term funds become more expensive than long-term funds, then banks doing maturity transformation can have terrible problems, especially if they have kept long-term loans on their books instead of them. securitize. They have to refinance their long-term loans at higher interest rates than they get from those loans.
Banks are not the only ones to be penalized when short-term interest rates exceed long-term rates. Between 1980 and 1995, one-third of U.S. savings and loan associations failed because high interest rates from the Fed at the time raised the cost of their funds above rates. fixed interest on long-term mortgages on their books.
When loans become less profitable, banks tend to cut loans. Typically, they do this by tightening lending standards, which makes it more difficult for borrowers to get loans. So if an inverted yield curve means they are actually losing money on loans, banks could tighten lending standards significantly. This graph from the St. Louis Fed post suggests that is exactly what they are doing. For example, in 2000, when the yield curve collapsed to minus 0.3%, the proportion of banks tightening credit standards rose from less than 10% to 60%:
Of course, this chart doesn’t tell us whether the tightening was due to the inversion of the yield curve itself or to general economic factors. So the St. Louis Fed asked banks how they would react to a moderately inverted yield curve. The answer was bluffing:
Many of those interviewed indicated that they would tighten lending standards or pricing terms for each major loan category.
And the reasons they gave?
- The loans would be less profitable compared to the cost of the bank’s funds.
- Banks would be less risk tolerant.
- The economic outlook could be less favorable or more uncertain.
If the survey responses are to be believed, the correlation between an inverted yield curve and the tightening of bank lending standards shown in the graph is causal. Banks respond to an inverted yield curve by cutting lending. And if the banks cut back on their loans, the economy tends to slow down.
But an inverted yield curve is in itself an indicator that the economy is slowing down. So if banks cut their lending in response to an inverted yield curve, the slowdown is magnified. So, in the words of the St. Louis Fed:
An inverted yield curve could do more than predict a recession: it could actually cause one.
We must indeed be concerned about the possibility that the yield curve of the US Treasury will reverse.