Inverted Yield Curve

The Last Bastion of the Recession Proponents

The story goes as follows: the inverted yield curve, the situation in which the interest rate on short-duration bonds (treasuries) is higher than the interest rate on long-duration bonds, predicts economic recessions with unmistakable accuracy. Therefore, given that the curve is inverted as of January 2024, the recession is bound to happen. We have a few comments on the assumption above, which raise some doubts about the prowess of the indicator

We hear: The inverted yield curve has been negative 9 times since the 1950s and each time a recession has followed. So, if the record is so good, this time curve inverts it is safe to assume that the recession will follow.

Sure, this is an interesting data point, but let’s not forget that it also gave a false signal in 1966, so the accuracy is 9/10. Additionally, expanding from the USA to the Global perspective, in 1995 Japan had an inverted curve which wasn’t followed by a recession, and in 2011 EU had an inverted curve which was followed by economic expansion. The same was the case in Australia in 1981, 86 and in 2019. Although these are different countries, they all have market economies and can be reliable data points.

Furthermore, the yield curve has been inverted on-and-off for a long time now. It’s a fact that economies evolve in cycles, so recessions inevitably happen. The only major “Western” type economy that has avoided recession for multiple decades is Australia, which has had an unusual level of foreign investments over the same period, namely from China, preventing Australia from falling into recession even in 2000 and in 2008, the toughest years in global markets. If the curve is inverted long time, the recession will hit eventually, but that doesn’t necessarily mean that it was predicted or even predetermined by the yield curve.

We know that the Fed and the ECB set the overnight interest rates, but it’s the market that determines the mid and long-term rates, and as the Fed and later ECB are going to start cutting the rates, as we expect it to happen in the H2 of 2024, the yield curve is also expected to flatten out. Especially, if the long-term investors get wearier of the increasing debt-to-GDP ratio of nations, in the post-COVID, making defaults more likely and hence pushing the long-term lending rates higher. The above moves should normalize the yield curve, (i.e., make it ascend again), which encourages investments TODAY, instead of pushing it towards TOMORROW – a major reason why economists explain the inverted yield curve as “recessionary”.

Our problem with zoning in on the yield curve is that it leaves out the inflation discussion, which has been a major component of the economic cycle over the last 3-4 years. If the current inflation rate becomes a new normal and the long-term inflation sets at around 3%, that will negatively affect the economy in direct and indirect ways. It will make borrowing and therefore the life of SMEs harder, and across the board decrease the valuations of the companies, especially of those firms backed by Venture Capital.

As it relates specifically to midsize and startup firms, given that we expect long-term rates to settle at a higher rate than in the pre-COVID environment, SMEs should focus on increasing margins today to become more bankable. As we are increasingly seeing, selling stories vs current cash flow has become increasingly difficult over the last 2 years and it will likely stay the same for another 18 months. If increasing the cash flow is a difficult feat to achieve in the short term, then maintaining the same level of revenue but converting it into trackable RECURRING (ARR) or subscription-based can and will also make a compelling case when working on obtaining financing.

Prepared by the Argo Advisory Insights Team

Argo Advisory | Published: January 2024

Sources:

LSEG | St Louis Fed | Financial Times