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Yield Curve is Disinverting: Lessons from Past Crises
Althea Spinozzi
Spécialiste Fixed Income
Commonalities between the Early 1990s, Dot.com and Great Recession crisis:
- High Interest Rates Leading to Recession: High interest rates, initially implemented to combat inflation, often precipitate economic slowdowns and lead to recessions. This pattern was evident in the early 1990s, 2001, and 2007-2009 recessions, where the Federal Reserve's rate hikes to control inflation contributed to the onset of economic downturns.
- Yield Curve Inversion and Normalization as a Predictive Indicator: The inversion of the yield curve consistently preceded each of these recessions, making it a reliable early warning signal of economic trouble. However, a recession did not begin until the yield curve normalized and then steepened further.
- Two-Year vs. 10-Year Yield Movements: Short-term yields dropped significantly in all recessions, while long-term yields varied, influenced by the Fed's actions and market expectations of future growth and inflation.
- Asset Class Performance: In all three scenarios, bonds have gained while stocks were crashing. Gold saw a significant price increase during the Great Recession of 2008, but it remained relatively flat during the early 1990s recession and the Dot.com bubble.
- Persistent High Unemployment Post-Recession: High unemployment rates often persist beyond the official end of recessions, necessitating continued policy support. The slow recovery periods underscore the importance of ongoing intervention to stimulate job creation and promote economic growth. This was particularly evident in the aftermath of the 2001 and 2007-2009 recessions.
Recession Period: The Early 1990s Recession, July 1990 - March 1991
Causes: The 1990 recession was primarily caused by a combination of high interest rates, the 1990 oil price shock, reduced consumer and business confidence, and the debt burden from the 1980s. The Federal Reserve had raised interest rates to combat inflation, which slowed economic activity. The invasion of Kuwait by Iraq led to a sharp increase in oil prices, further depressing economic conditions.
Inflation peak: 6.3% in October 1990.
Yield Curve Behavior: The yield curve began to steepen in March 1989, following the last Greenspan rate hike to 9.75%. The First disinversion occurred in June 1989, and it remained flat until a proper disinversion started in March 1990.
Recession starts: 3 months after disinversion, when the 2s10s spread was at 20bps.
Federal Reserve Actions: The Federal Reserve began cutting rates in July 1990 from a peak of 9.75% and continued past the recession's end until September 1992, cutting rates to 3%.
Asset class performance:
Yield Changes During the Recession:
- 2-Year Yields: dropped from 8.5% in July 1990 to 7% by the recession's end, shedding 150 basis points.
- 10-Year Yields: decreased from 8.4% to 7.9% during the same period. Despite a declining trend, yields remained relatively high due to inflation concerns, which still stood at 4.9% in March 1990.
- Following the recession, as inflation decreased and the Fed continued rate cuts, the 10-year yield dropped further to 5.2% by October 1993.
Reasons for Continued Rate Cuts Post-Recession:
1. Slow Recovery: The economic recovery was weak, with sluggish growth and persistent high unemployment. To stimulate economic activity and reduce unemployment, the Fed maintained a policy of lowering interest rates.
2. High Unemployment: Unemployment continued to rise, peaking at 7.8% in mid-1992. The Fed's rate cuts aimed to boost borrowing and investment, facilitating job creation and economic recovery.
3. Inflation Control: By September 1992, inflation had fallen, allowing the Fed more flexibility to cut rates further without the immediate risk of rising inflation. This focus on growth helped reinforce economic stability.
Recession Period: The Dot.com Crisis, March 2001 - November 2001
Causes: The 2001 recession was precipitated by the burst of the speculative dot-com bubble in early 2000, which resulted in significant wealth loss and diminished investment in the technology sector. This was followed by a broader decline in business investment as companies grappled with lower demand and shrinking profits. The economic downturn was further exacerbated by the September 11 terrorist attacks, which severely disrupted the economy, undermined consumer confidence, and heightened uncertainty across various sectors.
Inflation peak: 3.75% in March 2000.
Yield Curve Behavior: In mid-2000, the yield curve began to steepen as the Federal Reserve increased interest rates to combat inflationary pressures, which had reached a high of 3.5%. By early 2001, the yield curve disinverted and continued to steepen as the economy entered a recession, reflecting the contraction and ongoing economic adjustments.
Recession starts: 6 months after disinversion, when the 2s10s spread was at 100bps.
Federal Reserve Actions
- Rate Cuts Initiation: The Federal Reserve started cutting rates aggressively from January 2001, before the official start of the recession, in response to the weakening economy and the bursting of the dot-com bubble.
- Continued Easing: The rate cuts continued throughout the recession and beyond, with the Fed reducing the federal funds rate from 6.5% in January 2001 to 1.75% by the end of 2001.By July 2001, inflation started to drop below 3% and dropped to 1.14%by January 2002.
Asset class performance
Yield Changes During the Recession
- 2-Year Yields: Dropped from around 4.5% at the start of 2001 to approximately 2.3% by the end of the recession.
- 10-Year Yields: Decreased from around 4.9% to 4.5% during the same period, reflecting lower long-term interest rates as the Fed’s rate cuts took effect and inflation expectations moderated.
- Following the recession: 10-year yields decreased from 4.5% in November 2001 to 3.2% by June 2003. Within the same time period 2-year yields dropped from 2.3% to 1%.
Recession starts: 3 months after disinversion, when the 2s10s spread was at 40bps.
Reasons for Continued Rate Cuts Post-Recession
- Slow Recovery: The recovery was uneven and slow, with weak economic growth persisting. Continued rate cuts aimed to support the economy and boost growth.
- High Unemployment: The unemployment rate remained elevated, peaking at 6.3% in June 2003. The Fed maintained low rates to encourage borrowing and investment, aiding job creation.
- Inflation Control: With inflation under control, the Fed had room to keep rates low without risking significant inflationary pressures, allowing them to focus on fostering economic recovery.
Recession Period: The Great Recession, December 2007 - June 2009
Causes: The Great Recession, was primarily caused by several interrelated factors. The subprime mortgage crisis, driven by excessive risk-taking by banks, led to a high volume of subprime mortgages and widespread defaults, culminating in the collapse of the housing bubble. This triggered the failure of major financial institutions, such as Lehman Brothers, which in turn sparked a global financial crisis that severely impacted global credit markets. The crisis resulted in a severe credit crunch, as banks tightened lending standards, making it difficult for businesses and consumers to obtain credit. Additionally, high levels of consumer debt accumulated during the housing boom exacerbated the downturn, as rising defaults further strained the financial system.
Inflation peak: 4.7% in September 2005, but it resurged to 5.6% in July 2008 after dropping to 1.3% in 2006.
Yield Curve Behavior: The yield curve inverted first in mid-2006, indicating concerns about future economic growth. As the Federal Reserve cut interest rates aggressively from September 2009, the yield curve steepened sharply in the midst of the recession, reflecting lower short-term rates and higher long-term rates due to concerns about inflation and economic stability.
Federal Reserve Actions
- Aggressive Rate Cuts: The Federal Reserve started cutting rates from 5.25% in September 2007, continuing to reduce the federal funds rate to nearly zero (0.25%) by December 2008 to stimulate the economy.
- Quantitative Easing: To further support financial markets, the Fed implemented quantitative easing (QE) programs, purchasing large quantities of government securities and mortgage-backed securities to inject liquidity into the financial system.
Asset class performance
Yield Changes During the Recession
- 2-Year Yields:
- Dropped from around 4% in December 2007 to below 1% by June 2009, reflecting the Fed's aggressive rate cuts.
- 10-Year Yields:
- Decreased from about 4.5% to around 2% during the same period. Despite the Fed's rate cuts, long-term yields remained relatively higher and from 2% rose to 3.94% in the first half of 2009 due to concerns about long-term economic prospects and inflation.
Reasons for Continued Stimulus Post-Recession
- Slow Recovery: The economic recovery was slow and uneven, with weak GDP growth and persistent financial instability. The Fed maintained low interest rates and QE to support the recovery.
- High Unemployment: Unemployment peaked at 10% in October 2009 and remained elevated for several years. Continued low rates aimed to encourage borrowing, investment, and job creation.
- Preventing Deflation: With the risk of deflation high, the Fed's policies were aimed at preventing a downward spiral of falling prices and economic contraction. The low interest rates and QE were designed to stimulate spending and investment.
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