A normal curve with the two-year offering a lower yield than the 10-year is fundamental to how banks make money. Banks borrow short term at lower interest rates so that they can make long-term loans to borrowers at higher interest rates. The difference between those two interest rates, the positive spread, is their profit. If a bank is borrowing short term at a higher interest rate and making loans to borrowers at a lower interest rate, the difference is a negative spread.
In this interest-rate environment, banks would lose money by making loans. Not necessarily on all loans, but it does make some loans unfeasible and some less profitable, forcing banks to cut back on making loans, thereby choking off the access to credit markets that businesses need to grow.
This helps explain why bank stocks entered a correction on Tuesday. But the news is bad for all businesses.
When it becomes harder for businesses to borrow, many companies cancel or delay projects and hiring. Weaker enterprises go out of business because they lose access to credit, which in turn causes layoffs. When this happens, it takes about a year, on average, for the U.S. economy to slip into a recession.
Many market pundits say that the history lessons from a flattening or negative yield curve is not relevant in today’s world of massive central bank intervention, encouraging foreign investors to scoop up long-term U.S. treasuries because their home-country government bond yields are much lower.
But to believe that “it’s different this time” means you’d have to believe that the bank-sector math in the above example stopped working. Last I checked, banks still borrow at short-term rates and lend at long-term rates, as long as it is profitable. In other words, central bank-induced market distortions do not change the basics of the banker’s math I described above.
There are a few important caveats: In a longer-range chart going back to 1962, there has never been a recession that wasn’t preceded by an inversion of the yield curve. Yet it doesn’t happen overnight. In fact, stocks have risen in the 18 months after an inversion, though after that all bets are off. Also important: This is a market stat that specifically refers to an inversion between the two-year Treasury and 10-year Treasury bond.
It looks more like that is going to occur, but it still has not happened. On Tuesday the 10-year was at 2.9 percent, still above short-term rates, if not by much — the two-year was at 2.8 percent. On Tuesday it was the five-year Treasury that slipped below the two-year and three-year bonds. In the last three recessions, the curve of the three-year and five-year had inverted an average 26.3 months before the recession.