RED ALERT! Canada’s Yield Curve is Inverting

The yield curve in Canada shows signs of inverting. We need to watch this carefully as it is a strong indicator that we are heading towards a recession.

This week the rate on 3-month Canadian t-bills went higher than all the other rates out to the 5-year bond.

Here’s why this is important:

The yield curve is a graphical representation of the interest rates for debt instruments over different maturity dates. It normally looks something like this:

Economic actors prefer present goods to future goods, so future goods can only be exchanged for present goods at a discount. This gives rise to the phenomenon of interest (hence the term “discount rate” in finance when determining the present value of future cash flows).

The normal yield curve shows that the farther out in time you go for the maturity date, the higher the interest rate. There are two basic reasons. First, there is the issue of inflation, and lenders must take into account the depreciation of the monetary unit over time. Because the money supply is always expanding, the purchasing power of money tends to fall over time. Money paid back in the future is worth less with each passing year.

The second reason for the normal yield curve shape is that the default risk increases over time. The risk of default might be quite low over one year. But over ten years? Twenty years? Uncertainty is greater over that time period. The longer the debt takes to mature, the more one is subject to default risk, and so lenders compensate for this by demanding a higher rate of return.

This explains the shape of the normal yield curve.  But there are unusual situations where the yield curve inverts — the short maturity end of the curve has a higher rate than longer-term debt.  This is not normal, for reasons that should be obvious in light of the preceding discussion.

Putting aside the yield on the 1-month t-bill, we can usually assume that if the 3-month t-bill has a higher rate than the 30-year bond, the economy is going into a recession.

This implies a short-term liquidity crunch. Borrowers are starting to panic over their misguided investments due to artificially low short-term rates. They see impending losses. They will pay more for a 90-day loan than for a locked-in 5-year loan.

Meanwhile, the lenders are growing fearful about the short-term state of the economy as well. A recession pushes interest rates lower because the economy is weaker. Lenders are willing to give up the inflation premium they normally require. They nail down today’s higher long-term rates by purchasing more long-term bonds — which raises their price, and pushes down the rate.

Remember, when central banks are expanding the money supply, they buy up short-term t-bills to bid up their prices and push down their yields. The monetary expansion misallocates capital — investors and businessmen put more money into projects than the “real” economy can support, hence the “boom” phase preceding the “bust.” An inverted yield curve — rising short-term rates — signifies a liquidity shortage. Money is desperately needed right now to sustain capital projects.

(A detailed scholarly treatment of this issue can be found here — it’s a Ph.D dissertation, so it’s interesting albeit kind of dull).

So the inversion of the yield curve normally signals a recession. However, the yield curve is not fully inverted. The 3-month bill’s rate is still less than the 10- and 30-year bond rate. But these longer-term rates are plummeting rapidly.

Look at this 10-year yield totally nosediving:

And the 30-year treasury bond is plummeting as well — investors are giving the Canadian government their money for 1.833%, when just four weeks ago it was 2.3%. A year ago it was a solid 100 bps higher. Investors are giving Ottawa their money for less than 2% for 30 years. The world has gone insane.

(Although if it makes you feel better, it’s even more insane over in Europe. I mean seriously, people are lending the government of France — FRANCE! — money for 10-years at 0.5%. What the heck?! But it’s sweet deal when you’re a primary dealer and can just buy total crap like French 10-year bonds and flip it to the ECB.)

Despite the Bank of Canada’s recent surprise rate cut, the Bank of Canada has been significantly slowing the rate of growth of its asset purchases in recent months, as I reported a few weeks ago.

At the same time, down south, the Federal Reserve — the central bank of our biggest trading partner — has ended QE3 and its balance sheet no longer showing any net growth.

I am not clear how the BoC’s recent rate cut will factor into this, nor am I clear what Yellen and the Fed will do if the US economy shows signs of panic (QE4?), but I think the inversion of our yield curve is related to all this. Remember, short-term rates are lowered by periods of central bank monetary expansion because they buy up debt at the short end of the curve with newly created money. All signs have pointed to the end or at least slow down of high monetary inflation by these central banks. Businessmen who thought all this investment in capital was justified because of distorted interest rates are getting a wake-up call. The truth is manifesting in the debt markets.

So watch the yield curve in Canada closely in the near future. If the 3-month rate goes above the 30-year rate, I’d say there is a 90% chance of recession within six months. If the inversion doesn’t go all the way out to the 30-year, then it may not indicate recession but it still suggests slower growth going forward.