The narrowing of the spread between long-term rates – such as the 10-year T-bond – and the short end of the curve is a stylized fact of the economic cycle. When an expansion phase advances, inflation tends to accelerate. This leaves the central bank little choice but to raise key rates, but in general, monetary tightening is only partially reflected in higher long-term rates. At some point, they will no longer respond to the tightening of the central bank’s policy, and to the contrary, they could even decline.

Traditionally, a flattening movement is followed by an inverted yield curve. In the past, we have observed that the outbreak of a recession is preceded by the inversion of the yield curve between the long and short ends. An inverted yield curve is thus a conditional predictor of recession: recessions are preceded by an inverted yield curve, but an inversion is not ineluctably followed by recession. In this case, it is a false alarm.

It has also been observed that there is a long and variable time lag between the inversion of the yield curve and the outbreak of recession. In a rigorous statistical analysis, two American researchers, James Stock and Mark Watson, concluded in 2003 that there exists “indications that the slope of the yield curve was a serious candidate as a leading indicator for predicting economic growth and recessions, although the stability of this proposition was debateable in the United States and it did not answer the question of whether it was applicable to other countries.” One possible explanation is that interest rates do not depend solely on real growth and inflation prospects. Demand for bonds with long maturities also reflects the need for risk hedging and portfolio diversification at a time of higher equity market volatility, because investors expect the correlation between equity and bond prices to remain negative. Moreover, years of unconventional monetary policy have squeezed the term premium (risk premium for investing in long-term bonds), which has been negative for several years in the United States. This squeeze on the long end has contributed to the flattening of the yield curve.

Despite econometric scepticism and the bias created by quantitative easing and the positioning of investors, the yield curve is still a very popular leading indicator. This is probably due, at least in part, to the fact that it can be monitored in real time. Moreover, if enough people believe in an indicator, even one that is clearly imperfect, then it takes on greater importance and ends up influencing behaviour. According to the Federal Reserve’s October 2018 loan officers’ survey, bankers faced with a lasting inversion of the yield curve would tighten their lending conditions or raise their rates: they would interpret the inversion as signalling a deterioration in the economic environment. In other words, the interpretation of a signal ends up fuelling the very dynamics that the indicator was supposed to predict. A sustained flat or inverted yield curve could create some discomfort for investors, who would interpret it as an early warning signal of economic and financial turmoil. Yet, there is no reason to be alarmed as long as fundamentals are still looking upbeat (revenue and earnings growth, a healthy labour market, accommodating interest rates, and abundant financing).

Faced with the dilemma of trusting the imperfect signal of the yield curve or observations of fundamentals, market operators will quite likely shorten their investment horizon, thereby contributing to a cyclical increase in volatility. To resolve their dilemma, the yield curve must begin to steepen again, either because fundamental data does not weaken (in which case long-term rates would rise again), or because they deteriorate sharply. In this case, investors would expect monetary policy to be eased and rates at the short end of the curve would drop significantly.

In conclusion, rather than focus on the risk of an eventual inversion of the yield curve, what really matters is the reversal of this trend. After a long cycle of monetary tightening, it is the moment when the Federal Reserve is about to lower its key rates that we are likely to see a real questioning of growth prospects and that confidence would drop.