COVID-19 and its unpredictable changes to economic activity and composition have sent economists into a panic to deliver some direction as to where the economy is headed, and what are going to be the effects.

On June 4, Australian Treasurer Frydenberg announced Australia is headed toward a recession, with unemployment and economic growth levels contracting from the current 6.2% and 1.4% respectively. Similarly, in America, unemployment rates have reached historic highs of 14.7% where more than 50% of all African Americans are unemployed. However, as the world searches for answers and solutions, the Yield curve is an important economic indicator that provides useful insight as to what is coming for the global economy.

A standard yield curve is upward sloping and graphically plots a relationship between the percentage yield of debt securities such as bonds against their maturity. In contrast, an inverted yield curve illustrates where long-term debt instruments – tools used by firms to raise capital – have lower yields than short-term instruments of equal risk. This simply produces a situation where “short-term interests exceed long-term interest rates.”

Figure 1: Standard upward sloping yield curve, representing a non-linear relationship between maturity and yield.

Economist Howard Keen reveals that the yield curve reliably maps business cycle fluctuations through the following process – in an expansion and shifting toward an economic ‘peak’, the relative demand for liquidity increases and short-term rates rise. This increase becomes a self-fulfilling prophecy as investors continue to support debt instruments under the ‘herd mentality’ coupled with a positive outlook for growing output, prices and lending activity. However, as liquidity tightens, the probability that economic activities can reach the predicted heights of investor expectations will likely diminish. Consequently, long-run expectations of real interest rates change, causing a ‘flattening of the curve’ as short term rates do not translate into higher long-term rates to the extent they did previously. Keen conveys that this yield curve movement is directly tied to business cycle peaks, which typically proceed with contractions and potential recessions.

Changes in term structure and the yield curve’s ability as a prediction tool have been embraced since the 1980s under economist Campbell Harvey’s research and well utilised by central banks, namely the US Federal Reserve. The curve does not indicate explicit predictions but rather reflects fluctuations in both short- and long-term financial market expectations, alongside business cycle changes. Harvey himself describes the curve’s indicative ability; fearful investors increase their portfolio of 10-year US-Treasury Bonds, considered the safest and most widely traded security globally. Increased demand drives the bond yields, thus inverting the curve. Therefore, according to UK Economist Chris Dillow, the curve “embodies the wisdom of the crowds, forecasting recessions far better than economists do”. Yield curve inversions are also a way to inform shifts in real economic activity which is becoming vital to develop adequate policy responses, as global shocks in an increasingly globalised economy transmit with greater ferocity and reach.

Fear before COVID was demonstrated when in Mid-2019, 3-month treasury bills yielded a greater level than 10-year treasury bills as short-term loans dominated and longer-term lending decreased with reduced economic certainty. Since March 1st 2020, the US Federal Reserve’s fund rate was cut from 1.75% to 0.25% in the current period. Harvey reflects that before COVID, the global economy and the US in particular were speculated to have a “soft landing”, boosted by expansionary macroeconomic policy. After the pandemic, the yield curve and projected economic growth, unemployment and inflation have been “pushed into a bad situation”. This is evident as currently the entire yield curve is below 1%, due to ‘risk off-price’, where investors are scrapping risky assets and diverting funds into safer havens like Treasury bonds.

Figure 2: Recent movements of 10 year and 3-month treasury bonds. 10-year yields have significantly decreased/inverted

Some may regard the Bond Yield curve inversions as coincidental correlations with market declines which have been overthought as a way to explain economic fluctuations. Economists such as Keen see future curve inversions as less important due to the “absence of gross economic imbalances which typically proceeded past recessions”, such as that in the 1980 US equity market crash, and current financial market deregulations alongside the increasing role of foreign investment and export markets have allowed for greater flexibility. However as exposed by Dillow, UK yield curve inversions in 1973, 1979, 1988 and 2006 all successfully predicted domestic recessions in the short to medium term, and the curve has also been successful in predicting bear markets – indeed a fall in share prices is “more than four times as likely after the yield curve has been inverted”.

Figure 3: Grey lines indicate recessions, and red peaks indicate inversions of the bond yield curve. Reflects the direct relationship between negative economic growth and curve inversions

Predicting the future is an unfortunate impossibility. However, as policy makers, politicians and society holistically continue to tread in uncharted waters it appears that the Yield Curve can provide some insight into future market conditions, possibly informing the ideal responses in order to repair economic fractures.