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Forbes: “Why We Should Worry About The U.S. Treasury Yield Curve Inverting”

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An inverted U.S. Treasury yield curve is widely thought to signal 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 only an expression of investors’ views of 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 perhaps doesn’t signal quite what it used to. So maybe we shouldn’t worry about the yield curve inverting.

Or – should we? A new blogpost by the St. Louis Federal Reserve suggests that people might be right to be worried about yield curve inversion. And the reason is the behavior of banks.

The U.S. Treasury yield curve is said to be “inverted” when the yield on short-term bonds is higher than that on long-term. Normally, investors expect higher returns on longer-dated bonds to compensate them for the bond’s higher risk. But if investors think the short-term economic outlook is poor, they may sell off shorter-term bonds while holding on to longer-term ones, raising the yield on shorter-term bonds relative to that on longer-term bonds. This is why an inverted yield curve is often seen as an indicator of a forthcoming recession.

The bonds most widely used to measure the slope of the yield curve are the 2-year and 10-year bonds. So far, the 2 vs 10 year curve has not inverted, though it is very flat (the spread between the bonds was only 0.2% on December 28th). But early in December, according to another measure, the yield curve did invert: the yield on 2-year USTs briefly rose above the 5-year yield.

An inverted yield curve is awful for banks. This is because banks earn profits on the spread between their funding cost and their return on lending. When the yield curve is sloping upwards, it is in their interests to borrow short-term funds and lend long-term. This is known as “maturity transformation.” Maturity transformation has always been at the heart of simple “boring” banking, as exemplified in the traditional British bank manager’s adage: “Borrow at 3%, lend at 6%, be on the golf course by 3.” But if short-term funds become more expensive than long-term, then banks that do maturity transformation can be in dreadful trouble, especially if they have kept longer-term loans on their books instead of securitizing them. They must refinance their longer-term loans at higher interest rates than they earn from the loans.


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