(Newswire.net — July 12, 2016) — The U.S. economy may be facing its greatest probability of a recession since the Great Recession. This reality may be outside of the control of the next U.S. president. That analysis is largely based on the recent trends toward a flat yield curve. Flat yield is a situation where the difference between the yields between long term and short-term bonds is shrinking. The yield curve is a commonly used economic indicator that is used to predict the strength of the economy. Yields on short-term instruments have exceeded the yield on long term bonds in the months leading up to each of the last 7 recessions.
Another indicator of a weakening economy is an uptick in payday loans. According to Tim Latimer, CEO of Cashco Financial, their business has recently grown to over 50,000 active clients, and more than 300 million dollars in annual loans, suggesting that the Canadian economy may be facing the same pressure as the U.S. market.
Calculating Yield To Maturity
Historically the yields of long term bonds is higher than the yields of shorter term instruments. The higher yields compensate investors for the higher risks associated with the commitment to longer term investment.
The formula for yield to maturity is: Yield to maturity (YTM) = [(Face value/Bond price)1/Time period]-1
For example, a 20-year, zero-coupon bond with a face value of 5.73 today (the present value of this cash flow, 100/(1.1)20 = 5.73). Over the coming 20 years, the price will advance to $100, and the annualized return will be 10%.
Long Term Bonds
Long term bonds, especially long term U.S. Treasury bonds, are seen as a safe haven in times of economic turmoil, much like gold or other hard assets. Investors typically buy Treasuries when they expect weakness in the long term, coupled with low inflation (which erodes the capital value of long term investments). Capital also flows to Treasury bonds in times of economic weakness. Increased demand for these bonds drives the price up, and consequently drives the yield down. The weakness of the economies around the world, and especially in Europe, largely propelled by the “BREXIT” vote has cause a rush of capital seeking haven in long term U.S. Treasuries.
I recent months, the difference between the yield of three-month and 10-year Treasuries has closed rapidly. Ten-year treasury notes hit a record low yield of 1.375% last Tuesday. At the same time, 30-year Treasuries closed at 2.155% YTM, also a record low. This flattening yield curve is a clearly a signal of a coming recession.
“This relentless flattening of the curve is worrisome,” said Dominic Konstam, in an article in Forbes. “Given the historical tendency of a very flat or inverted yield curve to precede a U.S. recession, the odds of the next economic downturn are rising.”
All of this will cast a long shadow on the new U.S. president, whoever he or she might be.