Why we should welcome the yield curve inversion

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Canada’s bond market is emitting its clearest warning in decades that an economic downturn lies ahead.

All things considered, that is good news.

What would be far more concerning would be evidence that the Bank of Canada was allowing the economy to roar ahead, without any restraint in sight, even when inflation is still running vastly above official targets. That would be a nightmare scenario – reason to think that policy makers had lost control of the situation.

In contrast, the bond market’s current readings suggest that the Bank of Canada has matters in hand. Granted, there is the risk that the central bank could go too far in tightening monetary policy and thereby cause an unnecessary recession. But the alternative, in which policy makers dither about the need to bring inflation under control, looks even less attractive.

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The easiest way to read the bond market’s thinking is to look at the spread between the yield on the Government of Canada’s two-year bonds and the yield on its 10-year bonds.

On Monday, the two-year yield reached a full percentage point above the yield on the 10-year bond. A gap of this size is highly unusual. In fact, it is the largest such spread since the early 1990s.

In normal circumstances, 10-year bonds pay more than two-year bonds because most investors require extra yield to compensate them for the risks that go along with tying up their money for all those additional years.

When two-year bonds start paying more than 10-year bonds, as they are now, something is awry. This situation – a yield curve inversion, in the jargon – typically occurs before a period of economic weakness or recession.

The simple way to explain the inversion is as a forecast of bond investors’ long-term outlook for interest rates. A yield-curve inversion essentially means that investors expect interest rates to be lower on average over the next decade than over the next couple of years.

Why would investors expect interest rates to decline like this? Probably because they expect inflation to fall.

If inflation declines, bond yields and other interest rates also subside. This is because investors no longer have to demand a higher yield to buffer them against the corrosive effect of inflation on their money’s buying power.

Viewed this way, the deeply inverted yield curve on display today in Canada is actually a mixed message. Yes, it means a recession may be coming (although exactly when and exactly how deep is unclear). On a more positive note, it also means that inflation is likely to be considerably lower in a year or two than it is now.

Much of the same dynamic is on display in the United States, where the 10-year Treasury bond is now paying nearly 80 basis points less than the two-year Treasury. (A basis point is one hundredth of a percentage point.) That is the biggest inversion in the U.S. bond market since the early 1980s.

As disturbing as these readings may be, they are pretty much in line with what markets would like to see after the huge inflationary surge of the past year and a half. They are evidence that central banks are doing what is needed to bring inflation under control.

Critics argue that the Bank of Canada and the U.S. Federal Reserve run the risk of tightening monetary policy too much.

However, the Bank of Canada, and central banks in general, have good reason to make fighting inflation their first priority.

They want to avoid a situation like the 1970s, when expectations of high inflation became embedded in the economy. It required a devastating recession in the early 1980s to break that inflationary psychology.

The hope now is that a mild downturn will be sufficient to bring inflation under control. If so, the Bank of Canada could be cutting interest rates at this time next year.

Editor’s note: An earlier version of this article included an incorrect reference to the difference between Treasury bonds. This version has been corrected.