Inverted yield curve is 'very bad news': Campbell Harvey
Some economists are pointing to Canada’s inverted yield curve as yet another indicator of a possible recession that many have predicted for the coming year.
Short-term bonds are currently showing higher yields than long-term bonds in a reversal of the typical pattern. As of Monday, the yield for two-year short-term bonds were pegged at 3.8 per cent, while 10-year bonds yielded 2.8 per cent.
What does the trend mean, and why does it matter?
WHAT IS IT
“Inverted yield curves are very bad news,” said Duke University Finance Professor Campbell Harvey, who is credited with discovering the relationship between inverted yield curves and economic growth. The model has reliably preceded recessions in the U.S. and Canada over the last few decades.
A positive yield curve slope is good for economic growth, while “flat or negative is bad,” Harvey said in a phone interview. That reading has allowed the model to act as a reliable early warning signal for a recession.
Harvey explained that long-term bonds usually have higher interest rates than short-term ones, with a “premium for taking on longer-term investments” which are generally considered riskier.
But sometimes the pattern reverses, due to factors like people dropping riskier assets like stocks and investing in government treasuries which are considered safer, he said.
Another possible factor is rising inflation, which leads central banks to drive up the short-term interest rates in response. Central banks in both Canada and the U.S. are taking that tactic at the moment, and Harvey noted that the policy direction has led to economic slowdowns and recessions in the past.
University of Toronto economics professor Angelo Melino said the yield curve reflects what markets think will happen, and at the moment it shows an anticipation of falling interest rates.
“It's telling you that people think either we're going to get less inflation in the future or we'll get lower real interest rates in the future because of a recession, or both,” he said in a phone interview.
POSSIBILITY FOR A SOFT LANDING
Research published in October by the Conference Board of Canada pointed to September and August yield curve data in Canada as a sign of declining investor sentiment and negative market outlook – but noted that the pattern “does not necessarily indicate that a recession is on the cards.”
“What the inversion of the yield curve tells us is that investor sentiment has dampened, and the risk of recession has intensified,” Conference Board economist David Ristovski wrote.
In a phone interview on Monday, Ristovski noted that the yield curve inversion has grown since he published the analysis. His organization has pegged the risk of a recession occurring in the next 12 months as relatively high, but isn’t forecasting an outright recession.
“We are calling for more stagnant growth rather than an outright technical recession,” he said.
Harvey said he sees room for an engineered “soft landing” given the current picture of the labour market with excess demand for labour helping some sectors bounce back quickly from layoffs. He also pointed to short-term inflation, which is currently sitting higher than what people expect in the long-term, as another “wild card” in the direction of economic growth.
“It is possible that we could dodge a recession in a technical sense and still have slow growth,” he said.
Melino said the inverted yield curve is a signal “like the canary in the coal mine” that hints at economic downturn to come, but it must be considered with other factors.
WHAT SHOULD THE CENTRAL BANK DO
The Bank of Canada is set to raise interest rates again on Wednesday in its final policy decision of the year.
Overnight interest rates currently sit at 3.75 per cent after several successive increases and economists are debating the size of what Wednesday’s rate move will be, with many predicting an increase of 25 basis points.
Harvey said he would advise central banks in Canada and the U.S. to introduce lower-than-expected rate increases to avoid overshooting their objective of lowering inflation. Continuing with rate hikes for longer than necessary could “(cascade) into a recession, and potentially the dreaded hard landing recession, which nobody wants,” he said.
“For me, they should exercise caution,” he said. “I'd probably pause the increases.”
Ristovski said he expects the Canadian central bank will raise its central interest rate one more time but with a smaller increase than its most recent hikes.
He acknowledged the risks of raising central interest rates too aggressively and too quickly, but said he expects the Bank of Canada will bring down inflation without doing too much harm to the economy.
“We believe that the Bank of Canada will succeed in lowering inflation and we believe that Canada will not enter a technical recession,” he said.
With files from Bloomberg News