File picture of the New York Stock Exchange (NYSE). Investors are getting concerned about a key indicator signalling an approaching recession. Image Credit: Bloomberg

New York: Inversion of the US Treasury yield curve caused quite a reaction in markets and beyond last week.

Losses of around 3 per cent for the major US indices on a single day were accompanied by headlines screaming about the recession signals sent by the unusual occurrence: investors willing to receive less yield on 10-year bonds than on 2-years, even though they were committing their capital and taking risk for a longer period.

Yet, there is good reason to believe that all this was an overreaction, and not just because the curve had reverted by the end of the week. It’s likely to invert again in the coming weeks and months. Let’s consider now why a panic may not be in order.

The most widely cited reason for the recession signal of an inverted 2-10 Treasury curve is that rational investors will lock up their capital for an additional eight years only if they believe that the yield on the longer maturity will fall dramatically in future. This would happen if the US economy were to slow markedly.

Other factors are in play as well

That is certainly true. But it is not the only reason an inversion can happen. Two others reason seem more influential at this stage.

First, expected price appreciation is also a reason for investors to buy bonds even if the yield is low. Indeed, you need only look at what happened last week in Europe, where many bonds plunged further down in yield, driving the stock of negative-yielding bonds worldwide to over $16 trillion (Dh58.7 trillion). And such expectations of price appreciation are supported by the high likelihood that a large non-commercial buyer — that is, the European Central Bank — is on the verge of restarting its large-scale asset purchase programme while pushing its policy rates even more negative.

Second, bond markets internationally are much more connected than national economies. As such, what’s happening to US yields is also a function of what’s taking place abroad. This was highlighted last week when the US curve inversion followed the release of disappointing growth indicators from China, Europe and Singapore (including a worse-than-expected second-quarter contractionary GDP reading for Germany, Europe’s largest and most stable economy).

These two reasons also distort the traditional US economic signalling function of an inverted yield curve for Treasuries — a hypothesis that was supported by high-frequency data that pointed to a healthy consumer, the main driver of growth in the US.

All this is to say that worries about a US recession this year are overblown. But this is not to say there are no risks to the economy and the markets; and it certainly is not to say that the curve is unlikely to invert again.

Keep in mind the fear factor

A higher perceived risk of recession, even if based on distorted signals, can be dangerous if alarmist headlines lead consumers to cut back on their spending. And this would make the US economy even more vulnerable to a policy mistake and/or a market accident — a possibility that is accentuated by the probability that the curve will invert in the future as Europe weakens further, trade tensions escalate, and the ECB feels compelled to become more activist notwithstanding the limited likelihood of beneficial policy effects on the economy.

Second, the US is not immune to a weakening global economic context. This is particularly true for corporations that earn revenue and profit from overseas.

Finally, with the corporate sector more exposed, the stock markets will remain vulnerable to global economic weakness, opening up the possibility of a negative wealth effect if holders of stocks feel less well-off and cut back on their spending.

The reaction to the yield curve inversion was overblown. Yet it included an important warning to politicians around the world. Unless they step up their pro-growth policy initiatives, the risks of major economic and financial disruptions are increasing.

And with lower interest rates on longer-term debt, what a great time to initiate infrastructure programmes in both Europe and the US that can help crowd in private sector investment, enhance supply responsiveness and boost demand in a more sustainable fashion.