The media and economics talking heads are worrying about the current inversion of the yield curve, the graph of market-set rates of return on U.S. government securities of increasing lengths. Inversion is often interpreted as a sign that the stock market is expecting a recession—though, as Paul Samuelson quipped, the stock market has accurately predicted nine of the last five recessions.

Usually, the yield curve slopes upward, reflecting investors’ demand for better rates of return in exchange for tying up their money for more time. The commonly told story is that an inversion, where yields are higher for shorter-term securities than longer-term securities, shows that investors are “fleeing to safety,” moving their money from stocks and other risky investments to safe, multi-year U.S. government securities. That growing demand for longer-term Treasury notes reduces those securities’ yields.

For months now, yields on 1- to 10-year government notes have been eclipsed, off-and-on, by shorter U.S. government securities. However, this week the inversion has grown more pronounced, making big headlines.

I’ve long been puzzled by this idea of investors “fleeing for safety” into government 3-, 5-, 7-, and 10-year securities. Since the Great Contraction of 1929–1933 that ushered in the Great Depression, the longest economic contraction (last decade’s “Great Recession”) lasted only 18 months, and most contractions have lasted for less than a year. So, if investors are fleeing to safety, shouldn’t they be scooping up T-bills (government securities of less than a year) or, at most, government notes of 1 or 2 years? Those low-yield securities would pay off around the trough of the anticipated recession, which would be a good time for investors to move back into more aggressive, higher-yielding investments. If that’s the case, then the only inversion we should see would be at the front end of the curve, with yields on notes of 1–2 years moving downward significantly, but much less change on longer securities.

Yet, these “flight to safety” inversions are said to include 5-, 7-, and 10-year notes, and those are moving downward now. Admittedly, even under my theory those notes’ yields should decrease a little bit because they would reflect the falling returns on the shorter notes. But right now the annual return for 10-year notes is hovering around that for 2-year notes, and 5-year notes are yielding less than any other U.S. security. Are investors expecting a 4- or 5-year recession? If so, that would rival or surpass the length of the Great Contraction and come close to the length of the worst downturn on U.S. record, the miserable 1873–1879 recession.

Another puzzle: If investors are fleeing to safety, why would the yield curve invert? Given that the typical recession lasts less than 12 months, shouldn’t investors primarily be scooping up T-bills and lowering those yields more than the longer notes? Thus, the yield curve shouldn’t invert; rather, the front of the yield curve should move downward and it grow even more positively sloping. Yet, returns on T-bills are down, but not nearly as sharply as the 2- to 5-year notes.

So what sort of “flight to safety” is this?

I asked my Cato colleague George Selgin about all this, and he replied that the commonly told story is wrong. There are reasons why an inversion can signal a coming recession, one of which has to do with investors’ expectations of future Federal Reserve rate cuts rather than expectations of a recession. Former Fed chair Janet Yellen’s recent comments to Fox Business Network about the inversion draw on this rate-cut idea.

(A political note from me to President Trump: If you’re unhappy with the “CRAZY INVERTED YIELD CURVE,” don’t demand Fed rate cuts.)

George further points out that the correlation of inverted curves and recessions is a post-hoc relationship, and that according to a widely used forecasting model the current inversion suggests a 32% chance of recession. It follows, he adds, that “the safe bet is that a recession is not imminent.”

 

Thomas A. Firey is a Cato Institute senior fellow and managing editor of Cato’s policy journal Regulation.