Inverted Curves Not Only Signal Recession. They Might Cause One

(Bloomberg) -- An inverted yield curve can potentially harm U.S. economic growth and even cause a recession by pinching bank-lending margins and causing a contraction in loan activity, according to a blog posted on Thursday by the Federal Reserve Bank of St. Louis.

An inversion, when yields on short-term Treasuries rise above returns on longer-dated debt, has preceded every U.S. recession for the past 60 years. It’s currently not inverted, though the spread between two- and 10-year Treasuries has flattened.

Inverted Curves Not Only Signal Recession. They Might Cause One

As well as being a barometer of the economy, the yield curve may actually contribute to a slowdown when inverted, St. Louis Fed Deputy Director of Research David Wheelock wrote in the post.

That’s because banks tend to make money from short-term borrowing at lower rates which they lend at higher rates for longer periods of time. An inverted yield curve can make that business much less attractive.

“Bank profits get squeezed when short-term interest rates rise relative to the yields on long-term assets. This can lead banks to cut back on their lending, which, in turn, can put the brakes on economic activity,” he wrote.

Drawing on findings from the Fed’s October 2018 Senior Loan Officer Loan Survey, he noted that banks had viewed an inverted yield curve as a reason to tighten lending standards.

Factors they cited included concern that an inversion could make lending less profitable, reduced risk-tolerance among banks, and the view that it was a signal of a less favorable economic outlook.

“Thus, an inverted yield curve might do more than predict a recession: It might actually cause one,” Wheelock wrote.

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