Sabes et al (2022) investigate whether a yield curve inversion has historically been a good predictor of Eurozone recessions. They find that while an inversion occurred in all recessions prior to 2010, this stopped being the case after the start of quantitative easing. At the member-state level, the yield curve was found to be a much better predictor in ‘core’ economies like Germany, than in ‘peripheral’ ones like Spain. This was attributed to the latter group’s higher sovereign debt credit risk, which blurs the relationship between the yield curve’s slope and a potential recession.
Picture by Mika Baumaister, Unsplash
What is a bond yield?
Prior to discussing the implications of a yield curve inversion, it is important to explain what a sovereign bond yield is. Typically, it is defined as the present value return of the bond throughout its lifetime. Consequently, a bond’s yield can decline (or increase) due to a variety of factors, two of which are outlined below:
Lower interest rate expectations: a drop in the bond’s interest makes the already-issued higher-interest bonds more valuable. As a result, their market price increases, while their future cash flow remains constant. A higher buying cost with a constant return decreases the bond’s expected profit, which is the same as saying its yield has dropped.
Lower credit risk: a lower risk of default leads to more demand for the bond, and thus to a higher price. Consequently, the bond’s yield drops.
What is a yield curve inversion and how is it linked to recessions?
A bond’s yield curve refers to a line of the bond’s yield for different maturity dates (e.g., 6 months, 1 year, 10 years). A yield curve inversion is said to occur in the unusual situation when longer-maturity bonds have a smaller yield. In other words, lending one’s money for longer pays off less. This is said to sometimes occur when investors expect a recession, to which the central bank typically reacts by stimulating the economy through lower interest rates. In anticipation of the change, investors lend to the government more for longer, causing the longer-term bond yields to surpass short-term yields. This is one of the paths through which a yield curve inversion can be interpreted to reflect market expectations of a recession.
Has the yield curve predicted well past Eurozone recessions?
Sabes et al (2022) found the yield curve to be a strong predictor of Eurozone recessions prior to 2010. This is illustrated in Figure 1 below, which shows the difference between 10-year and 3-month Eurozone bond yields. A negative value shows a yield curve inversion, as it shows that the 3-month yield exceeded the 10-year one, which is what happened in all pre-2010 recessions. However, it is interesting that this was not the case in the last two recessions. The authors attribute the change to the European Central Bank’s quantitative easing policy during these years.
Figure 1: A yield curve inversion occurred in all Eurozone recessions prior to 2010
DATA: Sabes et al (2022), Bonsai Economics. Note 1: shaded regions indicate periods of recession. Note 2: Yield spreads are derived using the difference between the 10-year and 3-month yield
What about member state recessions?
At the member state level, the authors highlight the yield curve’s different predictive power for ‘core’ economies such as Germany compared to ‘peripheral’ ones like Spain. More specifically, while almost all yield curve inversions in Germany coincided with a recession this was hardly the case for Spain (see Figure 2, below). While the authors offer no detailed explanation for this, they highlight that it could reflect Germany’s risk-free status, compared to Spain’s. This observation offers an interesting insight into the yield curve’s predictive power: it can be higher in countries whose debt is considered by the market as risk-free (e.g., Germany, US) than in countries with a larger default risk.
Figure 2: In Spain, yield curve inversions occurred frequently outside a recession
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