Dec 07, 2018

Housing Trends

The Inverted Yield Curve: Is This Time Different? 

An indicator that has preceded every recession since the 1950s flagged twice this week, just six months shy of the longest economic expansion on record. The yield curve historically has been an accurate predictor of slower market conditions, but it is not without its nuances. Our Managing Principal of Advisory, Tim Sullivan, sat down with our Director of Economic Research, Ali Wolf, to discuss what the yield curve is and what it could mean for the economy in the near-term.  

social-hero-yield-curve-ali

To start with the basics, why don’t you remind the readers what the yield curve represents.
The yield curve charts out the return, or yield, an investor would get from a low risk, low return government bond. In this case, we are talking Treasury bonds. There are different terms for the investment, ranging from one month to 30 years. Oil prices, geopolitics, domestic policy, inflation, monetary policy, and investor sentiment all influence bond yields.

Define the relationship between bond prices and yields.
They have an inverse relationship. When there is less demand for a bond, the price will go down and the yield will go up. The opposite holds true as well.

I know you are about to get technical. Before you do, relate what all this means for housing?
The bond market is highlighting a heightened sense of risk in the coming years, but I still do not believe we will fall into a recession in 2019 or even early-2020. In fact, housing is poised to benefit from the flight to safety by bond investors into 10-year Treasuries because the yield is highly correlated with mortgage rates. The 10-year yield peaked this year around 3.2%, the same time mortgage rates almost touched 5.0%. Yields on the 10-year are down nearly 40 basis points, which suggests we could see rates fall back towards 4.6% in the near future. That’s good news for affordability and could reignite price-fatigued buyers.

You bring up an interesting possibility with a pullback on mortgage rates. There is clearly a relationship between the bond market and housing industry. Explain what the yields should look like in normal circumstances. 
Normally, yields are upward sloping in that they are low for a short period of time and high for a long period of time. This is because the government has to pay more to keep your money for longer. When market dynamics start to change, you’ll hear that the yield curve is flattening or even inverting.

An inversion flips the normal yield profile, meaning short-term bonds pay a higher yield than long-term. 

Tim Sullivan, Managing Principal

Upward sloping, good. Got it. What does an inversion represent then?
An inversion flips the normal yield profile, meaning short-term bonds pay a higher yield than long-term.

That sounds like a change in perceived risk.
Exactly! The inversion captures the fear of a downturn on the horizon.

I’ve heard people say an inversion causes a recession but that simply isn’t the case, is it?
Nope. The inversion is a symptom rather than a cause. If you take a step back, the yield curve is just a gauge of investor sentiment. Faltering confidence can certainly impact economic growth, but the inversion itself doesn’t cause a recession.

What has inverted so far and what’s left?
The first relationship to invert was the 5 year-3 year in early-December and was followed by the 5 year-2 year a day later. The 10 year-2 year curve, which is the preferred leading indicator, has yet to invert.

But that could change quickly, right? 
Yes, it could. Historically we have seen the 10 year-2 year lag the shorter-term yields by about a month and the difference between the two yields is at the lowest level since the mid-2000s. This tells us an inversion over the next 30 to 60 days is likely.

Final question: recession yay or nay?
Once the 10 year-2 year inverts we have historically seen a recession begin within 6-24 months, knowing 6 months is an outlier. Looking at today’s economy, I can’t say it doesn’t indicate a recession is forming, but there are some things that suggest ‘this time is different.’ Quantitative easing in other parts of the world has put downward pressure on foreign bonds, including Japan, the UK, and Germany. For investors seeking a higher yield, this makes the 10-year Treasury a more attractive alternative, which puts downward pressure on the US 10-year note. Furthermore, we haven’t seen the pickup in inflation that typically corresponds with a strong economy, which has also kept the longer-term yields lower*. These atypical pressures on the 10-year make the relationship between an inverted yield curve and recession less certain than in the past, but every expansion has had an excuse for why it is unique.

It seems clear that we will be ringing in 2019 with a new layer of uncertainty, but our team is here to help.

Note: Data last updated end of day December 6, 2018.

Please contact us to hear how your team can stay nimble in the new year.

Featured Writers

We cover topics around housing, policy, markets, and technology.

Ali Wolf

Director, Economic Research

Ali Wolf

Director, Economic Research


Tim Sullivan

Managing Principal

Tim Sullivan

Managing Principal


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