Is Australia’s Inverted Yield Curve signalling recession?

by Raymond Chan

In our first edition of Latte with Ray, we would like to draw your attention to the Australian Yield Curve. On 3rdFebruary 2015, Reserve Bank of Australia (RBA) decided to cut rate by 0.25% to 2.25%, citing weak domestic demand growth and high unemployment. Latte with Ray believe the inverted yield curve is in fact the reasons why RBA will make an early move.
 
Yield Curve: “A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.” Investopedia.com
 
Inverted Yield Curve: “An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.” Investopedia.com

Phillip Anderson (phillipanderson.com.au) demonstrated how that the rate differential between 90 days bank bill and 10 year bond can be used as a guide for the nation’s economic health and more importantly (sometimes) the direction of the economy. When the short term interest rate is below the long term rate, the yield curve is said to be positive. A positive yield curve is indicating an economy that will grow (or continue growing) in the near future. When short term interest rates are higher than long term rates the yield curve is said to be negative or inverted. Inverted yield curve may suggest the economy may go into recession. This happened in 1974, 1983, 1991. Having said that, we also had inverted yield curve in 2008 (during GFC) and 2012 (during European Banking Crisis) without going into recession. In 2008, our former treasurer Wayne Swan followed our G20 counterparties and boosted the economy by fiscal stimulus (and resulted in massive budget deficit). In 2012, the European Banking Crisis was resolved by Super Mario’s “Whatever it takes”.

In Jan 2015, the yield curve has again turned negative (or inverted) with short term yield (2.53%) running higher than long term yield (2.44%). This sparks the talk of Australian going into recession. We all know RBA cut rate in its first meeting but the future market is now factoring in 40% chance of another Rate Cut  as at 10th Feb 2015In the past, the future market is pretty accurate in pricing in RBA action. The RBA will need to address the issue of inverted yield curve over next few months. As such, we see a good chance of another rate cut before June.
 
Australia is fortunate to have the official cash rate still way above zero bound. This buffer will provide Glenn Stevens with sufficient firepower to stop us from going into recession.
Further, we noted that the inverted yield curve is caused by Bull Flattening as shown in Chart 4. The Bull Fattening means the long-term rates are decreasing at a rate faster than short-term rates. This causes the yield curve to flatten as the short-term and long-term rates start to converge.

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