24.April.2021 – US

The yield spread shows that economic recessions overlap. How about this time?


The yields on US treasury are a useful economic indicator showing the status of the economy. Usually, during economic recession the yield spread curve decreases because when short-term interest rates exceed long-term rates, market sentiment suggests that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall, according to Investopedia.


Therefore, many cite the decreasing spread between long-term and short-term US treasury as a harbinger of economic recession. In general, the yield on long term bonds should be higher because investors need to be compensated for more uncertainty, higher inflation and less liquidity in the long run. However, if it is lower than that of short term bonds, which are heavily influenced by central banks policies rather than long term economic fundamental, then it means something is wrong.


The graph below shows that an inverted yield curve has preceded every recession in the last 40 years, and this holds true for the past 60 years as well.


Yield spread and unemployment rate

Source: Federal Reserve Bank of St. Louis

Note: Green colored area shows times of economic recession


Economic recession also entails increasing unemployment rate, which is also clearly visible in the graph above. Unemployment rate decreased as the yield spread continued to fall during times of economic expansion, and increased as the yield spread increased during economic recession.


If this pattern holds true for the future, then this time yield spread should have jumped because there was an explosive increase in unemployment rate caused by the COVID-19.


Perhaps the pattern does not hold true this time because many expect that this to be a temporary economic recession, not structural simply because of the ephemeral nature of pandemic.


Will this bode economic growth onward after a brief economic contraction?


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