US: Why is an inverted yield curve concerning? - NBF

According to Krishen Rangasamy, analyst at National Bank Financial, the FOMC will be particularly concerned about the potential for an already flat U.S. yield curve to invert, i.e. 2-year bond yields rising above 10-year yields.

Key Quotes

“While yield curve inversions were not all followed by recessions in the past (e.g. 1998) they remain a decent predictor of an economic downturn ─ the last three U.S. recessions were all preceded by yield curve inversion. So why is an inverted yield curve often followed by recession?”

“A higher fed funds rate (which raises the short-end of the yield curve) can be a problem for interest-sensitive sectors of the economy such as business investment, the housing market and even consumption of big ticket items such as durable goods. Low long rates, often a result of investor concerns about the economic outlook and lower inflation, can hurt financial institutions which make some of their profits by borrowing short-term and lending long term. In other words, yield curve inversions are not favourable to financial intermediation.”

“It’s no coincidence that inverted yield curves are often followed, albeit with a lag, by a moderation in credit and hence slower GDP growth.”